Thursday, January 01, 2015

Best Practices in Trading: Risk Management

We're kicking off 2015 with a series of posts on best practices submitted by readers.  Thanks to all who shared ideas.

We begin with reader Vlad, who is a discretionary trader of forex, gold, and DAX.  He sets a maximum loss limit per day (1.0%); week (2.5%); and month (10%) for his trading.  He explains, "That has removed a great deal of the stress from trading, knowing that no one trade or series of trades can bring me down."

The best practice here is risk management:  the prevention of deep drawdowns is worth many pounds of come-back cure.

Readers trading for hedge funds, where capital is levered, will almost certainly set different percentages from Vlad.  A loss of 10% in a month would be wholly unacceptable at many places where I have worked.  Personally, I would not want three months of hitting my downside level to place me in a situation where I had to make over 40% on the remaining capital just to break even.  Vlad's basic concept of setting loss limits for trading, however, is quite sound.

I look at it this way:  if I have a hit rate of 50%, then I will have 25% odds of two consecutive losing trades; 12.5% odds of three consecutive losing trades; 6.25% odds of four consecutive losing trades; and a little over 3% odds of five consecutive losing trades.  If I place 50 trades in a year, guess what?  I will almost certainly encounter strings of four and five consecutive losers.  I need to be able to survive that risk of ruin.  If I allow myself to lose 10% of my initial capital on each trade, I will likely get to the point where I need to double my remaining money to break even.  If I allow myself to lose 1% of capital on each trade, any expectable run of losing trades is unlikely to impair my account--or my psyche.

One of the practices that has served me well over the years is to enter trades with one-fourth to one-half of my maximum position size.  I've found that, when I'm wrong in a trade, I'm usually wrong early in that trade.  Keeping my risk exposure modest initially enables me to lose less money if I'm stopped out quickly, and it allows me to add to my position if my scenario unfolds as planned.  If I'm sized maximally, moves against me become a threat.  If I'm sized more moderately, moves against my position can pose further opportunity.  That's a great place to be psychologically.

Finally, loss prevention in trading is greatly aided by diversification.  If you have two or more trading systems or trading methods that each have positive expected returns and are relatively uncorrelated in their return streams, you then create a situation where the expectable series of losing trades for any one method can be buffered by the returns from the others.  Diversification can also occur in the larger picture of our money management.  My trading capital is but a fraction of my total investment capital.  I have many fixed income investments, for example, that throw off a reasonable yield each year.  If I were to have a losing trading year, I would still harvest income from my larger portfolio.

Vlad's point is an important one:  risk management is the best psychological management.  It is very difficult to keep our heads in the game if markets are handing our heads to us with adverse moves.  Playing good defense sets us up for taking full advantage of offensive opportunities.

Further Reading:

Best Practice:  Reading in Parallel

Turning Best Practices Into Best Processes