Saturday, October 03, 2015

Taking Intelligent Risks: How To Stay In The Trading Game

You have to risk money to make money.  You have to make sure you don't risk so much money that you can lose your stake and go out of business as a trader.  Bet too little and you never make a good return on your capital.  Bet too much and you court career risks.  So much of trading success boils down to taking intelligent risks.

Here is a useful calculation tool that can tell you the probability of hitting a drawdown threshold.  

Let's say you have $1,000,000 in your trading account, you place roughly two trades per day (500 trades/year), and you're willing to lose $200,000 of your capital before you shut down.  Your win rate is 50% and the average size of your winners is 30% larger than your losers.  You're willing to lose 1% of your capital ($10,000) per trade.  The odds of your hitting your downside limit--even with that edge--is 8.6%.

Suppose you cut your trades in half and can take only the best trades, those in which winners are 50% larger than losers.  All else being the same as above, you now have only a 0.4% chance of hitting that downside barrier.

Alternatively, lets say you overtrade and place 1000 trades in a year and now your average winner is only 10% larger than your average loser.  You now have nearly a 64% chance of tapping out.

The challenge, of course, is that markets change and our hit rates and relative sizes of winning and losing trades vary over time.  To stay in business, you want to plan your risk taking around conservative estimates of performance, not the most optimistic ones.  By studying your historical performance, you can see how you trade at your worst and ensure that in any repeat scenarios you'll stay in business.  

In my own trading, I keep daily loss limits to 0.5% of capital and I'm willing to lose 10% of my total capital before tapping out.  If I were to place one trade per day and lose my edge entirely (50% hit rate; average win same as average loss), I would have a 35% chance of hitting my stop out level.  If I place one trade per week, the odds drop to 0.4% probability of tapping out.  A huge part of risk management comes from selectivity in trading:  by taking the very best setups, maximizing odds of success, and taking fewer trades, we can ensure that we stay in the game--even if our edge leaves us for a time.

This is why overtrading is so deadly.  It increases the probability that we'll have a streak of losers that knock us out of the game.  The eye-opening reality is that most traders could cut their total number of trades in half or even more, size up those best trades, retain the lion's share of their profitability, and keep their drawdowns modest.

We win the game and stay in the game not with low risk taking or with high risk taking, but with smart risk taking.

Further Reading:  Risk Intelligence