Tuesday, June 09, 2009

Managing Trading Risk: Learning How to Lose

The previous post dealt with managing risk within the trading day. At a larger level, however, every trader must manage risk across a trading career.

A while back, a trader told me he was doubling his money each year in the market and asked if I wanted to invest funds with him. He offered a verified track record of his results. I immediately declined. My rule is that, over time, a trader will always draw down at least half of his or her targeted return rate. Anyone who guns for 100% returns annually will surely, at some point, experience a 50% drawdown. That's not for me.

Risk and reward are always proportional. Those who understood that did not invest with Madoff.

A trader told me that he made a sizable six figures in a day of trading. Later, he wrote to me in a tizzy because he had lost six figures. Another one of my rules is that you should always trade small enough to comfortably weather five consecutive stop outs. If you trade enough, that series of losers *will* occur. Risk 10% of your capital in your trades and it's Russian roulette: eventually you'll come to that chamber that has the bullet of five consecutive losses.

If 20% of my capital is the maximum that I can countenance losing over time, I am going to trade smaller when I draw down 5%, smaller still when down 10%, and smaller yet when down 15%. As I'm trading worse, I'm risking less. I make it more difficult to hit my 20% threshold because I'm putting less capital at risk during drawdown periods.

Conversely, by risking a fixed fraction of my capital when making money, I naturally achieve greater risk/reward as I am trading well.

I know from experience that, at some point over time, I will draw down 10 times what I'm willing to risk on a single trade. If I risk one percent of my capital in a trade, I'd better be prepared to endure a 10% drawdown in capital at some point in the future. If I risk 5% of my capital in each trade, I'll eventually lose at least half of my money. Probability and psychology guarantee slumps; wise traders plan for them.

So much of trading success is knowing how to lose.