Evolve Your Mindset

Efficiency Formula: New Paradigm in the Risk Management

Hello, Trader!

Have you ever been through one of these two situations in your career?

  1. You were earning money for many days and lost all your money in just 1 day.
  2. Lost your emotional control and ended up making many trades during the day (overtrading).

I’m absolutely certain of it.

Almost all traders go through these 2 problems in any stage of their career.

And, with me, it wasn’t different.

However, seeking to solve these problems and find a way to help my students to improve their performances, I developed a new way to think about the management risk in the trading, through the usage of the efficiency formula.

The Efficiency Formula Discovery

Let me tell you a secret. I have the habit to take notes daily of my mental state and behaviour as part of my operational routine, I named it as my traderlog.

I’ve been doing that for years. That’s the way I found to increase my self-consciousness as trader and maintain my mental state (mindset) favorable and consistent.

Seeking to find a behaviour pattern that might help me to avoid both the days of desproportional losses and overtrading which happened sometimes, I decided to revise my notes thoroughly.

And I found something really interesting.

I realized that before these days of lack of control, happened some operational patterns:

  • Days that I had almost reached my daily-stop loss and made trades with more lots to recoup.
  • Softly positive days, in which I almost outweighed my daily-stop loss.
  • Days that I made many trades and my result was almost 0 x 0
  • Days that I decided to try out with a position size much higher than normal and lost all the profits earned in that day.

Analyzing this discovery, I could realize, clearly, which that days of big losses and overtrading were the “tip of an iceberg”, just the final result of a lack of risk consciousness hidden process, which forecasted the upcoming disaster.

Finally, I was increasing desproportionally my risk exposure and having very bad results. Eureka!

A New Paradigm in the Risk Management

Since the beginning, I suspected that the concepts which I am going to present to you in this article were original and unpublished.

However, to confirm the originality of this discovery, I got in touch with one of the greatest role models worldwide in traders training, the great Brett Steenbarger, author of the book Trading Psychology 2.0.

Talking to him by email, I described the concepts that I was developing, asking if he knew someone who already managed the risk that way.

His answer got me very happy and confirmed my expectations:

Hi Rafael,
Yes, I very much like your idea of measuring risk-taking efficiency. I have not seen this idea described anywhere else. (…) Excelent idea!

Brett Steenbarger

It is so cool, isn’t it?

Now, before talking about the efficiency formula and its implications, let me tell you a little bit about the traditional way of risk management.

The Limits of the Traditional Risk Management

The traditional way (or more common) of thinking about the risk in the trade is always related to the daily-stop loss concept, a limit of loss per day which the trader takes and must respect with discipline.

You’ve heard that advice: Set your daily-stop loss and be disciplined, stop trading when you reach your stop-loss limit.

The big problem of this simplistic view is that the trader doesn’t monitor his risk appetite, which actually, is a psychological factor.

If you make your risk management using only the financial results as reference, it won’t help you to become conscious about that behaviours which may be “preparing” a disaster in your account in the future.

I will give you an example:

The trader is almost reaching his daily-stop loss, and should stop trading. But he increases his lot and make one more trade, which works out, and he ends up the day softly positive.

Many times we get happy and consider this kind of day as positive, don’t we?

But, this way we are judging ourselves just by the financial result of that day, and not by our process.

In fact, this day wasn’t a gain one!

It was a day where the trader took an exaggerated risk and, in case you repeat this process unconsciously, you may be “making the bed” for one of that terrible desproportional loss days and overtrading.

Calculating the Total Risk (TR)

The way that I found to avoid these disasters of big losses in an unique day and overtrading, it was to start calculating what I named Total Risk or TR.

TR is calculated summing all the risk taken (accepted stop-loss) in the trades of the day.

Example:

Let’s suppose that the trader made 4 trades in some day:

  • Trade 1 – Accepted stop-loss, if it’s wrong= $100.00
  • Trade 2 – Accepted stop-loss, if it’s wrong= $200.00
  • Trade 3 – Accepted stop-loss, if it’s wrong= $100.00
  • Trade 4 – Accepted stop-loss, if it’s wrong= $150.00

The Total Risk Taken (TR) by the trader is: 100+200+100+150= $550.00

Calculating your Efficiency

Well, now that you already realized the importance to monitor your accumulated risk and how to calculate your Total Risk, let’s see the efficiency formula in itself.

Here it is: E = NR/TR

E= Factor of Efficiency

NR= Net Result (gross result-operational costs)

TR = Total Risk

It’s a simple formula, but very powerful.

The great insight is the idea to measure your net result in relation to your total risk taken.

Let’s see an example of its usage in practice:

You made 6 trades and got a TR of $800.00 but a Net Result of +$240.00.

Using a formula, your efficiency in relation to the total risk taken is of 240/800=0,3 or 30% 

Note that, despite of getting out positive, your factor of efficiency is low.

In this case, for example, you still must look for improvements in order to mantain your average efficiency in a higher level!

There are many ways to apply this calc of efficiency in your day-to-day as trader.

The efficiency formula makes possible, for example, which you make estimates of performance more realistic, set your Total Risk Permitted (TRP) and, mainly, the use of efficiency monitoring creates a process and a routine which will help you to avoid the two big problems mentioned during this whole article.

The main process derived from the use of efficiency calc is that you enforce yourself to register, trade by trade, your risk taken and net result, monitoring this way your efficiency during a trading session.

This way, your conscious of risk gets more present, keeping you from losing control or being surprised by days of desproportional losses.

If you want to control the overtrading and avoid desproportional losses in the market, and also evolve exponentially your performance, start to use this new concept in your risk management!

Good Studies and Good Trades,

See you!