Friday, November 27, 2009

Risk Management and Opportunity Maximization in Trading

A while back, I wrote on the topic of how to lose money the right way. If there is a holy grail to successful trading, it probably is risk management.

Risk management isn't just about keeping losses down; it also means taking maximum prudent advantage of opportunities that present themselves. It's taking more risk than reward in one's trades that ultimately can lead to failure.

Here's a quick test that I periodically conduct for my own trading:

Take the 10% of your biggest winning trades for the year and calculate how much you made. Then take the 10% of your biggest losing trades for the year and calculate how much you lost. If you lost more than you made at the tails of your distribution of returns, you know that risk management is a potential problem for you.

When the size of your average winning trade is smaller than the size of your average loser, you can only compensate by having many more winning trades than losing ones. That puts considerable performance pressure on traders, especially during slump periods and occasions when markets shift their direction and/or volatility.

What doesn't show up in risk management reviews are trades not taken. The flip side of big losing trades is the failure to execute trades that would have been large winners. That is why it is important, not only to identify when you would get out of markets (to limit exposure), but also to identify what would get you "all in".

Many traders fail because they cannot limit their risk. Many others fall short because they lack the courage of their convictions. Somewhere between confidence and overconfidence lies the sweet spot for successful traders.