Friday, November 06, 2009

Trading Psychology and the Risk of Ruin

A reader commented on the recent post on mood and trading that he was battling his own moods after losing 17% of his equity in three trading days. Admirably, he expressed the desire to keep it together for his family.

But, of course, this isn't a mood problem. It's a problem of risk management.

If you trade frequently, it's only a matter of time before you experience runs of three, four, and five losers. That can be losing trades, losing days, or losing weeks. The laws of statistics dictate that if even if you are right on your trades 60% of the time or profitable 60% of days or weeks, you'll have a run of four consecutive losers 2.56% of the time. Trade enough and it *will* happen.

Of course, if markets change and you hit a period where your win rate declines, the odds of those consecutive losing runs increase significantly. With 50-50 odds of winning, you'll get four consecutive losers about 6% of the time.

So why is that important?

You need to be able to weather those periods financially as well as psychologically. You can't be so leveraged that a normal run of losers will generate deep losses in your account.

Recently, the day's high/low range for the S&P 500 average (SPY) has expanded, with quite a few days above 2%. The 20-day average range is about 1.3%. There are only two ways to lose 17% in three days: trade very high volatility instruments or trade with very high leverage. Both can be deadly when you are dead wrong.

What is helpful for me is defining a drop dead level for the year. In other words, what is the maximum I'm willing to lose in a year before I close shop entirely? Let's say for argument sake that I'm willing to risk 15% in a year to make 30% or more. That means that, if I start to approach the 15% limit--perhaps at 5% increments--I will scale back my trading size/risk, realizing that I'm not trading well. If I'm proactive in such scaling back, I should never hit my drop dead level and never blow out my account.

Such an overall risk plan helps an active trader set daily loss limits. Knowing I could have losing streaks by simple random chance and knowing that 15% can knock me out of the game for the year, I'm not going to want to risk more than 1% of my capital in any given trading day. That, in turn, will guide position sizing for each trade.

When we trade so large that strings of losing trades or days can take us out of the game, that is called "risk of ruin". If you have an edge in the market, it's only a matter of time before you accumulate profits. Everything else is risk management and making sure you stay in the game.