This is because i saw many times a trade is going in my favor (lets say 50 pips, not bad) and after that if my analysis was wrong price suddenly goes against me and touches my SL. I felt dissapointed not only because i lost a trade (this is always possible off course) but i lost that 50 pips that were already mine.
This money management tries to avoid that situation, is based on probatilities and consists on following:
For this example lets say 1 pip= 1 dollar
I open three positions at current price:
- Stop loss for all positions: 100 pips
- First target: 50 pips
- Second target : 100 pips
- Third target: leave opened ("lottery target")
At this stage im risking : 300 pips (300 dollars)
Even is price moves completely randomly there is a great PROBABILITY that will touch the first target and not my Stop Loss, simply because its nearer.
Lets say price moves 50 pips in my favor and touches my first target, i modify the SL and target as follows:
I have already 50 dollars on my pocket and simply move SL another 50 pips.
At this stage we have:
- I have three positions opened. Total risk: 150 pips (us$ 150 dollars)
- I took already 50 pips profits (us$ 50 dollar)
I price goes in my favor from here off course everything is wonderfull.
Lets be negative and assume trade goes against us and touches the stop loss. In this case we have:
Total loss: 150 dollars - Total profit: 50 dollar = us$ 100
We see the total loss was only one third (us$ 100) compared with the original us$ 300 potential loss. This is a great thing and happens most of the times because price simply usually touchse the first target more often than not.
The main advantage here is the first target called RISK REDUCTION TARGET.
I did a mistake, after taking first profit we have TWO POSITIONS opened. Then move stop loss 50 pips.
At this stage we have:
Total risk: 100 dollars
Total profit: 50 dollars
IF price goes in my favor= wonderfull
IF price goes against and touches both SL we have finally:
Total loss= 100 dollar - 50 dollar proft = 50 dollars
50 dollars: that is 1/6 compared with the original 300 dollars initial potential loss!!
I thinks this MM is very powerfull because it reduces the risk AS SOON AS POSSIBLE and will keep us profitable in the long term.
Professional traders always consider first HOW MUCH THEN CAN LOSE, novice traders on the contrary always think "HOW MUCH THEY CAN GAIN".
Probabilities favor having bigger TP than sl.
So, reducing position when half SL is hit, but not before hitting targets makes more money in the long run.
Always good to test for your specific application.
Van Tharp covers this:
- Im not considering here position sizing to make the post simple but we should consider that also into this complex equation. There are fixed and variable position sizing systems.
- Every system has pros and cons. I would say the main advantage here is that we reduced risk as soon as possible (opening three positions). The main disadvantage it that we took profits too soon and we could miss a potential big reward. We could also be spiked out before price going in our favor.
- Im not talking on my post about the third target, wich sometimes turns to be a long term profitable trade using a tested trailing stop strategy.
- I agree the PA is the most important thing here because not all trades have the same probability. Having said that this system could not be suitable for all traders. I like it because i always try to enter at the best price and have the SL very small.
- Not the "best" system for sure, just wanted to share it.