Elliot Waves

We are deliberately covering Risk Management before we get into training on specific trade setups.

Risk Management is actually MORE important than trade setups!

That may seem counter-intuitive, but it is true.

To be consistently profitable in trading, it is essential that you control losses.

Without Risk Management, you could be having a great, profitable year and one bad trade, with uncontrolled loss, could not only take away all of your hard earned profit, but put you in the red.

A couple of losing trades, with uncontrolled loss, could very well reduce your trading account so much that it would take months or years to earn it back, or worse yet, leave you without enough capital to continue trading.

You’ve probably seen warnings like this, when you sign up for a brokerage account or advisory service.

“Investing involves a great deal of risk, including the loss of all or a portion of your investment.”

You see these warnings a lot because they are true!

Many, many traders and investors have found out just how true the potential for loss really is.

We absolutely can MANAGE risk, but we cannot ELIMINATE risk. This section will deal with how to manage risk effectively.
Elliot Waves Trades uses strict Risk Management rules to minimize exposure to losses – at all times.

It is inevitable that some trades will lose. The key to profitability is keeping the losses small and the wins big.
We base our Risk Management on the “Risk of Ruin” tables developed by Prof. Nauzer Balsara
We control “Trade Risk” (the amount of potential loss on each trade) by using the guidelines for Position Size (the amount of shares to buy).
We always have Stop Loss levels identified and almost always have Stop Loss Orders in place (the exceptions are on some options trades, where the Stop Loss level then triggers an option trade exit.)
We cannot always control “Market Risk.” It is possible for news or some other event to cause the market or an individual stock to move dramatically – well beyond our carefully chosen Stop Loss level - and to incur more loss than we had planned for. It is also possible for a dramatic market event to cause many or all of our positions to hit or exceed their stops simultaneously resulting in a large loss in our trading account.
The only way to protect ourselves against “Market Risk” is to only trade the amount of money that we can afford to lose. It is not a good idea to trade our entire net worth. Each individual needs to assess what percent of their net worth is appropriate to trade with.

We never, ever move out stops for a bigger loss after taking the trade.

We focus on getting our stops in the right place, before taking the trade. It can be tempting to move them, to think that things will turn around. You may get away with it occasionally, but it is a really bad habit and can get you into trouble. It is possible to keep nudging the stop until you have far exceeded your risk control parameters and then you feel trapped into staying with the trade no matter what. It is critical to get the stops right in the first place and if the trade loses, just take the loss in stride and move on.

Do you think it is possible to be wrong a lot (to lose more trades than you win) …and still be profitable? The answer is Yes!

You can do this by putting the power of Statistics on your side.

Mastering the concepts that we are covering in this post are what helped me, turn the corner to becoming consistently profitable – and they can for you as well.

Many traders or investors make these mistakes:

 Not defining how much risk they are taking on each trade.
 Not controlling the risk of each trade.
 Not measuring their trading performance.

Whether a particular trade wins or loses is irrelevant…

What matters is the how well you and your trading system perform over time.

It is absolutely possible to project, with very high confidence, whether you will be profitable over time—or whether you will lose money.

 A trading system can produce big winners occasionally and still result in net losses over time.
 It is also possible to have a trading system that loses more times than it wins, but is highly profitable!

Trading approaches that have poor statistics create the "Risk of Ruin."

 "Risk of Ruin" means the trading account is likely to be drawn down to an unacceptable loss level.

In order to determine your “Risk of Ruin,” you need to know the two key statistics that both your TRADING SYSTEM and YOU are achieving in your trading.

We emphasize both the trading system and you because they go together.

You may be trading with someone else’s system, which they have proven to be profitable with, but you are unable to follow it the same way that they do.

There can be many reasons for this, including; a misunderstanding of the system, not following the established rules for the system or psychology problems that prevent you from trading the system.

By psychology problems, we don’t mean mental health problems or disorders, but rather ingrained beliefs, habits and behaviors that, for whatever reason, prevent you from following the trading system.

The Two Key Statistics that you need to measure are:

Win-Ratio: How many trades do you win vs. how many trades do you lose?

- E.g. 10 trades, 6 winners, 4 losers = 6/10 = 60% Win-Ratio

Pay-Off Ratio: How many dollars do you make for every dollar you lose?

- E.g. 10 trades, average profit = $2000, average loss = $1000

$2000/$1000 = Pay-Off Ratio of 2:1

We strongly recommend that you practice your trading in a Simulated or Demo account to generate your initial measurements for these statistics. Trying to determine whether or not you can trade profitably, with real money, can be a very costly experiment.

A good statistical sample for measuring your initial statistics is 30 trades. In order for the measurement to be valid, you have to have followed the trading system for all of the trades and not made changes to the rules during the 30 trades.

It is normal to find that you or the system are not performing well and decide to make changes of some kind. That is fine, you just have to start the testing over so that the statistics represent what you are really doing
Having tested your trading system thoroughly, with a statistically valid sample of at least 30 trades will accomplish three important things;

1) You will have proven that you can trade the system.
2) You will have the confidence to follow the trading system, even during periods of concurrent losing trades – you will have seen this before and know that it is normal.
3) You will be able to project, with confidence, whether or not you can trade the system profitably over time.
Once you have a valid statistical measurement of your trading of the trading system, you can use the Risk of Ruin tables to determine whether you can legitimately expect to be profitable over time, or whether you face the “Risk of Ruin,” meaning the risk of drawing your account down to an unacceptable level.

Above image is a Risk of Ruin table for a risk size of 2% per trade. The risk size of 2% means that you have selected a position size and stop loss level such that the most you will lose on the trade, the “Trade Risk” is 2% of your trading account.

*This is the amount of the “Trade Risk.” Remember, “Market Risk” can be larger.

We will cover trade size calculation later on.
In the table, you find your Win Ratio on the vertical axis on the left of the table and find your Payoff Ratio on the horizontal axis along the top of the table, then find the table value that corresponds to those values.

For example, a Win Ratio of 50% and a Payoff Ratio of 1:1 have a table value of 100%. Notice that 100% is in red. This is saying that with these performance statistics, you have a 100% chance of “Ruin,” of drawing down your account, unacceptably, over time. Not good…

Also notice that with the same Win Ratio of 50% and improving your Payoff Ratio to 2:1 results in a table value of 0%, meaning you have 0% chance of “Ruin.” That is good! The 0% chance of ruin also implies profitability.

Obviously, the deeper you are into the green area of the chart, the higher your profitability will be.
Risk of Ruin and Profitability are more sensitive to Payoff Ratio than they are to Win Ratio. Both statistics matter, but Payoff Ratio matters more.

Simply stated, a high Payoff Ratio means that your winning trades are bigger than your losing trades. That is what we want! We want to “keep our losers small and our winners big!”

There are two primary ways that we work to keep the winners as big as possible;
1) By only taking trades that have a high Reward/Risk Ratio (we will cover this more in module four when we talk about Trade Setups.)
2) By staying with the trends as long as possible (we will cover this more in module four when we cover Trade Management.)

We keep the losers small by following our trade size guidelines, which we cover in the next section.

We recommend a risk size of 2% per trade as a starting point. This may be a sufficient level for most traders to stay at. If your trading statistics justify moving to a higher risk size, then that can be considered

We will base our examples on a trade risk of 2%.

Again, we think that is a good place to start.
The math behind Trade Size Calculation is very simple. Here is how it works.

Trade Size Formula
STEP ONE: Calculate Your Dollar “Risk Amount”
Account Size ($) X Risk% = Risk Amount ($)*
Example: $50,000 X 2% = $1,000*
* Dollar Amount you can afford to lose on this trade if you get stopped out.
STEP TWO: Calculate Your “Trade Size”
Risk Amount($)/Difference Between Entry and Stop($) = Trade Size (Shares or Contracts)

It is possible to add to existing positions – to buy or sell more shares or contracts after your initial position in the trade. This is an advanced technique and should be fully understood before being attempted.

“Scaling In” to a trade is completely different than a popular technique called “Doubling Down” that some traders use.

Doubling Down is a great strategy when playing Blackjack. We believe it is a terrible strategy for trading because it increases risk, beyond the guidelines that we are teaching. The idea behind Doubling Down in trading is that if you get into a trade and it is going against you, you can add more shares at a lower cost thereby lowering your average cost basis on the position. The problem is that you also now have more money in the trade and will lose more if the stop is hit, more than the planned for, controlled risk that we established with our Trade Size calculations.

“Scaling In”, however, allows us to increase our position size without increasing risk....

Here is how “Scaling In” works:

The trade must be already in profit. For long trades, that means price has increased above the initial entry, for short trades, price has decreased below the entry.
The initial Stop Loss must have been moved, for a smaller loss than the initial Stop Loss level. We will cover how we move Stop Loss levels in module four when we discuss trade management.
Amount of shares to add to the position is calculated using the following math;

a. Potential Loss on Existing Position = (Initial Entry Price – New Stop)*Initial Number of shares.
b. Potential Loss Per Share on New Shares = New Entry Price – New Stop.
c. Amount of Risk $ Available = Maximum Risk – Potential Loss on Existing Position.
d. New Shares to Buy = Amount of Risk $ Available/Potential Loss Per Share on New Shares.

Above image shows the same example that we used for calculating initial Trade Size. Now the trade is in profit and we have moved the stop from an initial level of $3.99 to $4.50.

New entry price is $5.25. Using the math for scaling in, we can now add an additional 1360 shares to our position, bringing our new total position to 3360 shares (we had 2000 to start with.)

Because we had moved the stop up and used it to determine how many new shares to add, our total risk on the new position size is still $2000 if the trade is stopped out, still within our Risk Management Guidelines.

We don’t have to add the total amount of new shares. We can just add a portion, thereby being able to get more profit if the trade wins, but lowering our risk to less than 2% if it fails.

“Profitable Money Management Occurs When You Truly Believe That You Need It.”