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Introduction
The average trading account: up a little bit, then back down a little bit. Maybe a big gain here and there.
Then down a lot. Maybe the entire account is lost. Trading — whether it’s forex, stocks, bonds, baseball cards or coffee beans — is largely a losing game for most people who try.
Why is trading a one step forward, ten steps back experience for most people? There’s an answer. And it’s easier than you might have thought.
The most important number in risk management isn’t the number everyone focuses on. It’s the SOL number.
That’s right. The SOL number. Your SOL Quotient, or SOLQ, is your risk management IQ. It’s more important than your win percentage. More important than the size of the average win compared to the average loss (a false measure of security comes from a so‐called “2:1” risk to reward system, but more on that later). More important than your “profit factor,” or any other metric that I’ve ever seen.
Here’s the deal: I’ve studied over 25,000 trades, from over 2,000 traders, over the past 4 years. And I found a number that matters more than anything else. And the other metric — the profit factor and all those other numbers — were interesting, and sometimes useful. But they weren’t very good at forecasting the overall eventual success of a trader.
At least not like the SOL Quotient. Here’s the calculation:
NET PROFIT / MAXIMUM LOSS
That’s it. Your net profit divided by your maximum loss. But what does that mean? How do you get those numbers in the first place?
The best first step towards learning your SOL Quotient is to do some testing. You can backtest manually, by moving the charts forward one candle at a time and logging your results, or you can use backtesting software like Forex Tester or Tradestation.
You’ll need at least 30 trades, and optimally 50, to work from. This is not a sample set large enough to develop an entire trading system, but it is the minimum necessary to calculate your SOL Q.
One assumption here is that you actually did some testing. If you didn’t do any testing, you can also calculate your SOLQ from your live trading results.
Once you have 30‐50 trades, you simply look over those results and you calculate your net profit — the total amount gained over the course of your results. Then, using over the same data set, you look for the single largest loss. Then you divide your net profit by your largest loss. And that’s your SOL Quotient.
In the expanded edition of this eBook, coming in mid‐June 2007, we’ll look at some specific examples. But for now I just want to take one more moment of your time, and explain why I believe this number has made a huge difference in the success of thousands of traders.
A larger SOLQ is better. Why?
When you are focused on keeping your SOL Quotient high, you are trying to maximize your wins, and you are constantly attempting to reduce the size of your losses. For instance, with your SOL Quotient in mind, you will be far less likely to let a losing trade run for a long time, knowing that if you let it become a massive loss, you are going to have to divide that number into your net profit.
It’s the same thing you have heard so many times: the best traders keep their losses small and their winners big. This oft‐repeated mantra of risk management proved to be true in my research.
Let me say this a different way: a high SOL number means that your net profit was so great that it was many times larger than your biggest loss. A high SOL number means that your biggest loss has a very minimal effect on your total net profit. The question is, what are your losing trades do to your net profit? Will one bad trade wipe out your gains?
You want to be able to experience losses without wiping out your net profit. It’s not about the average win or average loss. It’s really about the biggest loss as a percentage of your net profit.
When you focus in your trading on making sure that you keep a great (high) SOLQ, here are some things that you do:
- You cut off your losing trades fast, because you know that you never want to have your biggest losing trade equal a big portion of your net profit.
- This creates an emphasis on reducing your losses, rather than trying to hit home runs. Learning to control your risk is infinitely more important than learning to make the big score, win the lottery, hit the jackpot, or in other words get lucky with a big win.
It is very difficult to learn to be a super-trader that can predict the exact peaks and troughs of the market. It is much, much easier to learn to close trades that are are costing you money.
It’s not completely unimportant that you have winning trades, or that the size of your winners is bigger than the size of your losers. But there is far too much attention given in trading literature to these metrics, when in reality most traders have never learned the simple lesson of closing their losing trades early. Admitting that we are wrong in our trading is inconvenient, embarrassing, and makes us feel like we’ve wasted time.
Some examples of calculating the SOLQ might help.
Let’s say that you have just completed a round of testing 50 trades for your new, absolutely brilliant trading strategy, and you have ended up with the following results:
MAXIMUM LOSS (the biggest loss you sustained): $10,000
NET PROFIT (all gains combined minus all losses combined): $100,000
This produces an SOLQ of 10. Why? Because:
$100,000 divided by $10,000 = 10
It’s that easy
Think about it: if you made a net profit of $100,000, and your biggest loss was $10,000 — that means that you could sustain 10 maximum losses in a row and still ended up at breakeven. That’s survivability.
The SOLQ challenge.
I’d like to offer you the chance to freely see for yourself if the SOLQ really is helpful or not. Here’s the challenge:
For the next 30 days, as you test or trade live, keep a note tacked on your computer screen to remind you to do everything you can to make sure you end up with the highest SOLQ possible.
This means that you’ll close out your losing trades. That you’ll do your best to let the winners ride longer. It doesn’t mean that at the first sign of the trade going against you that you panic and close it out. But it does mean that you are going to start thinking of your stop loss as the maximum you are willing to lose on a trade, but not the minimum.
If you do this just for the next 30 days, I promise that you can move from net losses in your account to at least breakeven trading, and from breakeven trading to profitable trading.
About the author
Rob Booker is an active proprietary trader, money manager and forex educator. Mr. Booker has trained hundreds of forex traders around the world, assisting them with developing their own trading systems. But more importantly, Rob focuses on helping traders deal with the mental, psychological, and discipline issues related to trading.
You can visit his blog at: http://www.piptopia.com. |
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