This week, in our series of insights from Jack Schwager's Market Wizards, we look at Ed Thorp’s incredible story that took him from the blackjack tables to legendary trader. (Read our last piece on a trader that turned $30K into $80 million here.)
Ed Thorp is a professor, PhD mathematician and the man who figured out how to make millions counting cards in blackjack. (He even wrote the book on it in 1962 - Beat the Dealer.)
During his trading career, he built an $800 million fortune and figured out how to price options years before Nobel Prize winners Robert Merton and Myron Scholes. This statistical edge helped him put together an incredible winning streak; over 19 years, he made money in 227 out of 230 months.
So, he has some credibility in dealing with risk. Here’s what he says is the best way to figure out how much you can afford to lose on any given trade.
In Jack Schwager’s Hedge Fund Market Wizards, Thorp points to the Kelly criterion as a way to calculate how much a trader can afford to lose on any given trade in order to (1) maximize his compounded return and (2) never run the risk of blowing up his account. The beauty of this is that TopstepTrader’s dashboard offers all the insights that you need to calculate what your own max loss should be.
We will do that using our latest funded trader, Fred's dashboard. We'll be using the three numbers circled in red to find out how much he should risk on each trade to maximize his return without risk of blowing up.
Here’s the formula:
F = PW - (PL/W)
F = Fraction of capital to bet
W = Average winning trade divided by average losing trade
PW = Winning trade percentage
PL = Losing trade percentage
Now, looking at Fred’s dashboard from his successful Funded Trader Preparation, we can see what his max risk on any given trade should be.
W = Average winning trade / average losing trade = $255.83 / $122.36 = 2.09
PW = Winning trade percentage = 45.45%
PL = Losing trade percentage = 54.55%
F = 45.45 - (54.55 / 2.09)
F = 19.35%
What F gives us is the percentage of capital that Fred can risk on any given trade. Given that he’s in a $50K account with a max daily loss of $1,000, Fred should only risk $193.50 on each trade.
Using this max loss, Fred can also figure out his position size and where his stop should be based on the product he's trading. For example, if he’s trading Crude Oil ($CLX7), each $0.01 is worth $10. That means that he could put the stop $0.20 away if he is trading one contract or $0.10 away if he is trading two. If he wants to put a stop even closer than that, perhaps because Crude is either breaking out or against important support or resistance, he can increase his size accordingly - even trading three contracts with a stop $0.06 away.
For traders in the midst of a drawdown (like our Performance Coaches are in their Trading Combine®), you can estimate what your max loss should be by changing the winning and losing trade percentages to the number you’re targeting. Or you can use the data as feedback to increase your average winning vs average losing trade size.
For anyone that has blown up a trading account in the past, paying attention to the Kelly criterion is a no brainer. It will give you comfort - provided you stick with it - that you will never do that again.
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