Wednesday, April 07, 2010

Growing Your Trading Size: How to Take More Risk

A developing trader recently asked me one of the most common--and important--questions that I encounter: How do I become comfortable growing my size and taking more risk?

One advantage to starting out trading small is that you have the time to make all your mistakes without wiping yourself out financially. Many traders take imprudent levels of risk early in their development and never survive their learning curves.

But learning to trade small has its downfalls. Once habituated to a given level of risk and reward, we can find it difficult to adjust to the much larger dollar volatility of returns when we trade larger. Nothing is more discouraging than making money over an extended period trading small, only to give it all back in a few losing trades once size is increased.

That larger size, increasing the dollar size of both wins and losses, can also magnify emotional responses to performance. Ironically, this can be as problematic after large wins as after large losses.

Three principles should dictate your trading development vis a vis the size and risk issue:

1) If a bump up in size *feels* much different to you, it's more likely to impact your trading adversely. Gradual increases that you adapt to thoroughly before bumping up your risk again can help you grow into a large trader naturally;

2) If you're not profitable and trading well at incrementally larger size/risk, don't bump up the size/risk further. Make sure you're trading well at your current level before expanding your business;

3) Follow your percentage P/L, not your dollar P/L. Get yourself accustomed to thinking in basis points (hundredths of a percent) and percents, not in absolute dollar amounts. That way, when you're down 50 basis points in a day on a $5,000,000 portfolio, it won't feel significantly different from being down 50 bp on a $500,000 portfolio.

In percentage terms, trading larger doesn't have to mean taking more risk. The key is risking a fixed portion of your portfolio value each trade, each day and growing your size as your portfolio grows. That will also have you cutting your size when you draw down.

Just remember: at some point, you *will* encounter strings of losing trades. Make sure your larger size will not dig you into a damaging hole when the inevitable slump occurs. Too many traders focus on trading big, when their proper focus should be on trading bigger.