Trading Systems and Money Management
What this domain tests
This domain tests whether you can turn a chart idea into a repeatable system and size positions so that no single loss is fatal. Expect expectancy, risk per trade, stop placement, drawdown and backtest bias.
Core rules
- A trading system needs entry, exit, stop, position size and filter rules. A signal without an exit is not a system.
- Expectancy = (win rate x average win) minus (loss rate x average loss). Positive expectancy is necessary before compounding matters.
- Risk per trade is usually a fixed percentage of capital (for example 1 to 2%). Position size = (account equity x risk %) divided by (entry minus stop). Wider stops mean smaller size, not larger risk.
- R multiple = profit or loss divided by initial risk. A 2R winner offsets two 1R losers before costs.
- Maximum drawdown measures the worst peak-to-trough equity decline; it drives the risk of ruin more than win rate alone.
- Backtests must include commissions, slippage, liquidity and out-of-sample testing; survivorship bias and curve fitting inflate results.
Worked example
An account has Rs 5,00,000 and risks 1% = Rs 5,000 per trade. Entry is Rs 102, stop Rs 98, so risk per share is Rs 4. Position size = 5,000 / 4 = 1,250 shares. If the target is Rs 110, reward is Rs 8 per share = 2R. Even if the win rate is only 40%, expectancy per trade = 0.4 x 8 minus 0.6 x 4 = 3.2 minus 2.4 = +Rs 0.8 per share before costs, i.e. Rs 1,000 on 1,250 shares.
Traps
- Sizing by confidence rather than by stop distance.
- Ignoring costs and slippage, which can turn positive expectancy negative.
- Optimising parameters until the backtest looks perfect.
- Risking a large percentage after a losing streak to get it back.