A Simple Yet Overlooked Way to Reduce Trading Losses

There are four broad ways to improve your trading results: 

1. Increase the size of profitable trades
2. Decrease the size of losing trades
3. Increase the percentage of profitable trades
4. Increase the number of trades you open (once you have a profitable Trader’s Equation) 

Each of those can be further broken down into subcategories. But if you think about it, any improvement you make directly or indirectly impacts one of these four areas.

Which of those areas have you worked on improving the most?

I can almost guarantee you’ve seriously neglected at least one of them. Can you guess which one traders neglect the most?

If you guessed “decreasing the size of losing trades,” you’re spot on.

It’s similar to what we see in business. Most companies focus on increasing their revenue as a way to improve their profits, but many overlook the possibility of reducing their costs. As a result, there are often simple inefficiencies and quick wins that go unnoticed.

This is what traders do too. They focus on increasing the size of profitable trades, or improving their success rate. But reducing the size of losses is often the low-hanging fruit that can lead to a quicker improvement.

I want to help you start addressing that in this article. I’ll walk you through a simple optimisation task you can follow that will give you insights on the loss side of the equation.

Before we get to that, we need to address a really important topic:

How Much Should You Risk On Each Trade?

Do you believe all trade opportunities are equal? Or do you think some are better than others?

I think most people will agree that each opportunity is different. The markets are dynamic and the context is always changing; even if there are similarities between opportunities, there are always many differences too.

So, should we risk the same amount on each trade?

No. That would be illogical.

That’s why most experienced traders use dynamic risk. The percentage we risk is adjusted based on the opportunity.

But this raises a key question: how do you decide how much to risk?

Beginner traders will often base it on the potential profit. The bigger the upside, the more they’ll risk on the trade. But this doesn’t take into account the potential downside and the probabilities involved. It’s a decision often driven by greed and doesn’t consider the full picture.

A better approach is to base your risk on the trade expectancy—the expected value of the trade once risk and probability are factored in. You want to risk more on high-expectancy trades and less on low-expectancy ones.

If you’re not already assessing the expectancy of your opportunities and you want to learn how to do it, check out the free training I prepared for you.

However, there is a downside to adjusting your risk based on the trade expectancy. In some cases, the opportunity may have a high expectancy but low probability. This means, each individual trade is much more likely to lose, but over time by trading those opportunities the profits will eventually overshadow the losses.

Trading low probability opportunities means you’re likely to be in a drawdown for a long period of time. And here’s the problem: this can trigger psychological traps that lead you to change your decision-making and sabotage your trading. If you’re risking more on those trades because they have a higher expectancy, the drawdown will be deeper and the negative knock-on effects will be amplified.

Therefore, in some situations it may be a better decision to adjust your risk based on the probability of the opportunity, assuming the trade still has positive expectancy.

If you're not already using dynamic risk like this, you need to start. That's the first step to improving the loss side of your Trader’s Equation. If you are already doing it, then let's move on to the next level with a simple calibration task.

How to Run a Risk Calibration

Running a risk calibration is a straightforward process to help you ensure that your percentage risked on trades aligns with the factors you're using to make decisions. This helps you fine-tune your risk management and potentially improve performance by adjusting where necessary.

Here’s the first part of the process step-by-step:

1. Add your trades and risk percentages to a spreadsheet
   Start by creating a spreadsheet. You’ll need a column for Trade ID (e.g., asset name and date) and another column for Percentage Risked on each trade. List all your trades in ascending order by the percentage risked.
2. Add a decision factor column
   Now, add another column where you include the factor that influenced your risk decision. For example, if you're basing your risk on estimated probabilities, list the probability estimates next to each trade (you may need to check your trading journal to get this information).
3. Check for alignment
   Look at the two columns side by side. Is the percentage risk increasing as the probability (or other decision factor) increases? If your risk calibration is correct, these two should be aligned. If they’re misaligned—meaning that you risked more on a trade with lower probability or vice versa—you may need to make adjustments.

If you have many trades, consider grouping them by percentage risked. For example, group all trades risked at 0.5%, 0.6%, 0.7%, and so on. If you do group them, add another column to show the number of trades in each group. This avoids you making inaccurate conclusions based on a small sample size.

Once you've checked for alignment, you’ll have a clearer idea of your calibration accuracy. A few misaligned trades might not be a big issue, but consistent misalignment means you need to recalibrate.

How to Recalibrate Your Risk

The first step is to review how your performance would have changed if you had been calibrated correctly. To do this, adjust the risk percentages on any misaligned trades to what they should have been and see how it impacts your overall performance.

If the adjustment improves your results, it’s a clear sign that you need to recalibrate your risk management. For many traders, the easiest way to do this is by using a checklist or reference table to ensure consistent decision-making for your risk percentages.

However, it’s not always a case of simple inconsistency. There may be specific situations or types of trades that are throwing you off, leading to inconsistent risk percentages. You’ll need to spend time digging into your trading journal to identify any consistent themes or patterns in those trades.

But what if your adjusted risk percentages make your performance worse?

In many cases, this doesn’t necessarily mean you perform better when you’re misaligned. The issue might simply be that you’re dealing with a small sample size. Before jumping to conclusions, try collecting a larger set of trades and redoing the calibration exercise. Using a trading simulator can speed up this process.

If your sample size is already sufficient, the problem is likely to run deeper than just having misaligned risk. Although this article is focused on the risk calibration, I’ll briefly outline a few more steps to follow that help most traders discover the real issue:

1. Group your trades by the decision factor: For example, if you're using probability estimates, group trades based on those percentages.
2. Add a column for actual outcomes: In the case of probabilities being the decision factor, add a column with the average success rate for each group of trades.
3. Compare your estimates to actual results: Assess whether the actual success rates align with your estimates. If they don’t, it suggests the issue might be in your decision-making process and accuracy of your probability estimates rather than risk calibration.

This simplified approach is just a starting point, and you may need to explore other areas in your trading. The goal is to help you risk more on opportunities that warrant it and less on those that don’t.

Lastly, make sure you’re working with a large enough sample size. If you’ve only got a few trades, the conclusions you draw won’t be reliable. So, your first step might be to gather more data before recalibrating. If you want to make sure you’re paying attention to the right things, get started with this free training to understand more.

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