The Mathematics of Trading

When I first started Trading I did not calculate much of anything regarding my system into Mathematical terms. As a kid I never liked math class. I could care less when two trains are on separate tracks when they will pass each other if they are 240 miles apart, and Train A is going 100 miles per hour and Train B is going 80 Miles per hour.

Maybe I should have paid more attention in math class. Good Trading is all about the Mathematics of your System, and specifically your Risk Management Rules. When I first started Trading I did not have a Mathematical Plan or a Risk Management System. I focused on Fundamental analysis, by reading books on Warren Buffett. Then Technical with charts, moving averages,software, and data. Then I read books on the Psychology of Trading. This all did for me all of nothing in the practical trading.

After coming across a book called Way of the Turtle by Curtis Faith I decided to calculate the mathematics of my Trading. For more specific advice please consult the book. I don't enjoy math enough to break it all down here on the web, even for too many detailed examples.

When getting into the Trading World I did not even consider math relevant to trading except to calculate my business expenses and trading profits. I thought that if I Traded according to my "system", then the math would "work itself out". I was wrong. I learned about the Mathematics of Trading the Expensive Way.

The Key is not to Expose too large of a percentage of your account to negative equity price movements.

You don't need to figure out the different risks that are in the market for your different positions, and over think what is happening in the market. You Don't need to over complicate the Situation. Simplicity is your friend.

You only Need to know 3 things

What % of Capital to Risk in any Trade
How to exit if the trade becomes Unprofitable
How to exit if the trade becomes Profitable

1. What % of your Capital to risk per Trade

First and by far the most important. At Risk means exposed positions to closed markets, and maximum loss of total account on a percentage basis. If Trader A lets his net account balance decline by 20% before exiting trades, then his account will be completely wiped out after only 4 more losing Trades. Trader B risks only 2% of his account on any Trade. Trader A has 5 Shots to figure out Trading. Trader B has 50 Chances to catch a big winner. You need to figure how much you can risk, and lose at least 10 times in a row. The self insurance policy of adequate capital reserves is your key to future profits, so it must be protected at all costs. You need to figure out exactly how many shares, contracts, ect that you can buy or sell at any time.

2. How to exit if the trade becomes Unprofitable

The main problem for the majority of Traders, and it can be the most devastating to your financial Statements. After you have followed Step 1, move on towards step 2. If you skip step 1 you could have losing trades with so much % of your account you won't need step 2. Step 2 is Simple. If any Trade decreases a percentage of your entire account equity to your max risk limit always exit immediately.

3. How to exit if the trade becomes Profitable

This is what we call a "High Quality" Problem. We all Trade to find the Winners. Mathematically how much reward can you expect based on how far the stock has moved in the past? How much extra Financial risk is in the Trade now that its winning? The Problem for most Traders is they get into winning Trades, and end up getting out too soon. Many Traders take a Large position size, and try to grab a few points. Essentially Risking more for Less. This also affects the way they trade. They are more prone to make Trading Errors.

The Mathematics of Profit Taking

If you are holding onto your losing Trades longer than your winning Trades it is going to be impossible for you to make any money. Setting Price Percentage upward Targets can work. You need to do the math yourself and the work.

You need to know what % of your net account are you going to take profits on. If you set a 2% stop Loss per trade, and booked profits after winning 8% moves, then you could have 3 for 1 losing Trades, and still be up 2% overall. If you could do this every day, compound interest would reward you handsomely.

If your taking 20% or more losses and cutting winners after 10%, that math clearly does not work out in your favor. You need twice as many winners as losers just to break even. The math will not work for you regardless of your method of analysis. Or your execution.

The Art of Profit Taking

After you understand the basic math on profit taking for your "system" you can always fine tune your process and presence in an the trading environment to Maximize your profits. This is can offer as much of a challenge as you would like. There are markets Trading anything and eveything 24 hours a day. The possibilities are endless.