Creating a Risk Model

How to Build a Risk Model

The following is best suited for traders who have a good number of trades per month, i.e. day traders or swing traders with good frequency.

When you first become consistently profitable, you will want to begin to treat your trading as a business.

The purpose of a risk model is to determine what percent risk, i.e. “R,” you should be using in order to achieve your monthly or annual return objective. Use either your trading results or backtest results to provide these four variables:

% of winning trades
% of losing trades
Avg winner
Avg loser

Expectancy = the average return of all your trades, i.e. what you can expect to make every time you roll the dice, on average.
Expectancy = (% of winning trades * avg winner) – (% of losing trades * avg loser).

Frequency = the number of trades produced by the system each month or year.

Risk model formula: Objective = Expectancy * R * Frequency


Win rate: 70.3%, Avg win: 1R, Avg loser: 1R
Expectancy: 0.406R
Frequency: 4.4/day, or 88/month. To be conservative, use 80% of this figure, or 70.4.
Formula: Objective = Exp * R * Freq
If objective = 20%/month, then
0.2 = (0.406R) * 70.4
0.2/70.4 = 0.406R
0.0028 = 0.406R
0.0028/0.406 = R
R = 0.0070

Conclusion: In order to achieve a 20% return/month, you should risk 0.7% per trade using this trading system.

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