Filter size by expected value and ruin

Five steps before the position is placed

Money management is described as five steps: identify the risks in a trade, choose how much risk to take, judge the return for that risk, accept or reject the pairing, and then carry out the decision.

Risking too large a share of capital is described as leaving a fair chance of losing the entire stake in one trade or a series of losers. Risking too little is described as leaving capital unused.

Capital preservation and the equity path

Preserving capital is presented as the first constraint, because leveraged markets can produce rapid losses as well as gains and any strategy may still lose money. Leverage is large notional exposure relative to account equity, which can enlarge both gains and losses.

An equity path is the sequence of rises and drawdowns from starting capital to later capital. That path can rise without a stated ceiling, including gains of 50 percent, 100 percent, or far more, but a 100 percent decline is described as ending the account immediately.

The route of the equity path is described as independent of whether analysis is technical or fundamental and as depending instead on risk and reward. Capital preservation is the constraint that keeping the account intact outranks seeking a larger payoff.

Risk, reward, and the pairing

Risk is defined as the amount and probability of one adverse event or a series of them. Reward is defined as the amount and probability of one favorable event or a series of them.

The risk-reward ratio is the pairing of how much can be lost against how much can be gained, used to accept or reject a trade before it is placed.

Risk is described as always present while a position or stake remains open, whereas reward is possible but not assured. Severe losses can force an exit from trading, while large profits are not described as doing so.

Expected value as a pre-entry test

When two plans each put 1,000 at risk, multiplying loss size by loss chance yields an expected loss near 1,000 if the loss chance is about 0.999, versus 500 if the loss chance is 0.5. That product is the probability-weighted loss: loss size multiplied by the chance that the loss occurs.

Expected outcome is the sum of each result times its chance. In a 50/50 case of +100 and -50, the expected result after two trades is 50, or 25 per trade. Expected value is the chance-weighted sum of possible gains and losses, used before entry to test whether a plan can stay solvent if it is repeated.

A method with a negative expected outcome is described as leading to eventual ruin. Expected outcome is presented as a long-run indication, not a result that is due on any given trade.

Ruin as the bound that ends trading

Risk of ruin is the chance that one loss, or a string of losses, exhausts the account and ends trading. Because risk remains present while a position or stake is open, the accept-or-reject step is described as coming before the decision is carried out.