Level 1 Reading charts · Part 6/7

Risk, Stops and Position Sizing

This article contains the one part of technical analysis whose effect is mathematically settled. Everything else in this course is interpretation. Position sizing is arithmetic.

Thinking in R

The distance between entry and stop is one unit of risk – one R. Every outcome is measured in that unit: a trade returning twice the risk is a +2R trade, whether it involved 40 or 4,000 in currency.

The distance from entry (1) to stop (2) is one unit of risk — one "R". Every target is measured in that unit: (3) sits two R above entry. Thinking in R makes trades comparable regardless of price level or position size, and shows immediately whether your hit rate fits your reward-to-risk ratio.

The benefit is comparability. Trades across different instruments, price levels and position sizes collapse into a single series of numbers from which hit rate and average outcome can be read – without one large winner dominating the statistics.

Position size follows from the stop

The order of operations is decisive and usually practised backwards. The correct sequence is:

Fix the risk per trade as a share of the account. A common range is 0.5 to 2 per cent.
Derive the stop distance from the chart – where the idea is refuted, not where your preferred loss would be reached.
Compute the position size: risk in currency divided by the stop distance per unit.

Example: a 20,000 account, 1 per cent risk = 200. Entry at 50, stop at 46, so a distance of 4. 200 / 4 = 50 units, a position worth 2,500.

Tighten the stop and the unit count rises while the risk in currency stays the same. That is the point: you do not choose the position size, you choose the risk – the size follows.

Expectancy

Hit rate alone says nothing. What matters is expectancy per trade:

E = (win rate × average win in R) − (loss rate × average loss in R)

At a 40 per cent hit rate, +2R average win and −1R average loss: 0.4 × 2 − 0.6 × 1 = +0.2R per trade. A system that is wrong six times out of ten is profitable. Conversely, a system with an 80 per cent hit rate that wins +0.5R and loses −3R is clearly negative: 0.8 × 0.5 − 0.2 × 3 = −0.2R.

Quoting only the hit rate means leaving out half of the fraction.

Drawdown arithmetic

Loss and recovery are not symmetric: the grey bar is the loss, the red bar the gain needed afterwards just to get back to even. Up to roughly 20 % the gap is small; from 50 % it explodes. Capping losses is therefore not caution, it is arithmetic.

Loss and recovery are not symmetric. After a 50 per cent loss you need 100 per cent to get back; after 70 per cent you need 233 per cent. This asymmetry is why capping losses matters more than hit rate: one large loss costs more than a long series of small wins brings in.

The same arithmetic sets the ceiling on risk per trade. At 2 per cent risk and ten consecutive failures – hardly exotic at a 40 per cent hit rate – the account is down roughly 18 per cent. At 5 per cent risk per trade it would be 40 per cent, and recovery becomes a multi-year project.

How such streaks distribute across many runs can be simulated: the Monte Carlo tool shows the range of possible paths instead of a single one.

Where the stop belongs

A stop marks the point at which the idea is wrong – not the amount you are willing to lose. Confusing the two is the most common mistake in this chapter.

In practice the stop sits beyond the zone whose break refutes the idea, plus a buffer for normal fluctuation. Placed immediately below the last low, it gets hit by exactly the noise every market contains – and later, in your own sample of trades , that shows up as a run of near misses that all ended just short of target.

The final article of this level puts technical analysis in context – what it can actually do, and what the evidence does not support.