Using a Fixed Risk Strategy

So far the analysis of historic trades simply tests the merit of continuing in the same manner as in the past. There are variations that can also be analyzed. Analyzing the past is using the historic returns data straight and unmodified, but it can be treated in a number of ways.

First it can be scaled up or down to find what the result would be if more or less contracts or shares were traded. Regardless of how the data is scaled it is kept constant during a simulation. This is the fixed risk method of trading - every trade risks the same amount regardless of the current equity in the account. This method answers questions like - If 3 contracts are traded instead of 1, what will the drawdown be? How much initial equity is enough to avoid a margin call?  From the last example on the previous page, here are the equity and drawdown curves for 2 contracts and 4 contracts.

As expected, both the equity and the drawdown curve are roughly doubled.

A Percent of Equity Strategy

Suppose that the risk is allowed to vary during a trial.  There are many ways this can be done and one way is to risk a percent of equity on each trade.  The idea is that by risking a fixed fraction of equity that after a loss a smaller amount is risked on the next trade to conserve equity and after a win the amount risked automatically increases.  This is a bit like compound interest for a win and a reverse compounding for a loss.  Using the same example the next curves show the fixed risk of 1 and a % Risk of 2%.  The fixed risk is the bottom equity curve.

At the left end the profit is improved a bit but at the right the improvement is strong. 

Drawdown is nearly unchanged.  This is because the drawdown is expressed in percent.  If the drawdown were in absolute dollar amounts then drawdown does increase as equity increases.

User Defined Risk

Percent of equity risk is an interesting exercise but it is somewhat unrealistic to apply to real trading.  The computer can cheerfully decide to risk an arbitrary amount on the next trade but when that translates to buying 2.482009 contracts our broker will point out the reality that only integral numbers of contracts may be actually traded.

Using the previous example, suppose the plan is to trade 2 contracts with an initial equity of $6,000.  When equity reaches $10,000 then 3 contracts will be traded and for each additional $4,000 in equity one more contract will be added.  This does not fit any risk method discussed so far.  To do this a user defined risk curve is created. Here is the curve for the method proposed.

The line at the $6,000 point is a marker showing where the initial equity is on the curve.  A risk of 1 represents 2 contracts, so a risk of 1.5 is 3 contracts.  Now compare risking a fixed 2 contracts against this risk method.  The equity curve is strongly higher and drawdown is increased by a small amount.


This is an example of a real plan for increasing profits with a realistic increase of risk with equity.


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Copyright 2002, Larry Sanders

Last update 2002.06.15