How does fixed risk and %Risk work? 

The Fixed Risk case

Suppose you have a series of returns data like this:

-2.5
-2.0
-1.25
1.75
2.25
5.0
6.25

Here is the returns chart

When using Tradesim in the Fixed Risk mode a return is randomly selected from this returns list and multiplied by the fixed risk amount.  If Fixed risk is 1.0 then we see that the worst loss is $2.5 and the best gain is $6.25.

The %Risk case

Suppose Start Equity is $10 and risk is 5% of equity.  This means in the first draw risk is $0.50 – so what happens if the $2.5  loss is drawn?  This is obviously more that the $0.50 which should be the maximum risk.

Since we want a maximum risk to be $0.50 - not $2.50 the data is normalized internally in the program.  Normalization is simply dividing each of the returns by the absolute value of the largest loss return.  After normalization the returns are.

-1.0
-0.8
-0.5
0.7
0.90
2.0
2.50

Note that the worst return is a loss of 1.  So as each return is drawn randomly, it is multiplied by the Current Equity times the %Risk amount.  Now the worst loss is $0.50.

Assumptions about the returns data

So how is this related to the returns data. 

In the Fixed Risk mode the assumption is that the returns used are from an actual trading method or trading simulation.  The largest loss is what actually happened or is expected.  The Fixed Risk value in Tradesim can be used to scale the returns up or down to explore the relationship between profit, drawdown and starting equity.  The returns, however are constant during a single simulation.

Note that the largest loss is likely due to a stop loss order or some exit strategy while the largest profit may be the result of a trailing stop or similar method.

Now for the %Risk mode.  The assumption is still that the largest loss is the result of some initial stop loss exit strategy, but that exit value changes with the current equity.  It is always a fixed percent of the current equity.  If current equity is $20 and %Risk is 5% then on this trade I will risk $1.00.  When equity is $ 1,000 the loss exit is $50. In actual trading you must adjust the stop loss and this may not be possible in all cases.

 

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Copyright 2004 by LSS Limited.

2004.05.13