Risk Management
To be successful you need to build a degree of failure into your risk management. It doesn't matter if you are fundamental or technicals based. It doesn't matter if you call yourself an investor or a trader. The math of winning doesn't discriminate.
Before taking any trades you need a plan and the most important part of any trading plan is the risk management. It's your insurance policy against a global market sell off that doesn't care about the value of any of your holdings. Risk management is there to limit the losses when you make bad decisions or you didn't follow your rules. It's there to limit the size of the hole you have to trade out of after a draw down. Most of all it's there to protect you from the risk of ruin. If you want to be trading in the future you need to stay in the game long enough to see the future returns.
The suggestions that are made below are what I consider the low risk approach. Knowing when to take more risk on special trades or take more heat risk on the account are advanced techniques for traders who have the psychology to stomach larger risk.
This will come with time spent in the markets.
Two very important questions you need to answer are How Much Shall I Risk on Each Trade? and How Much Heat Will I Expose My Account To on Open Trades?
How Much Should I Risk on Each Trade?
1% = 100 trades away from blowing your account.
2% = 50 trades away from blowing your account.
3% = 33 trades away from blowing your account.
If you risk 1% on every trade you take you will always be 100 trades away from blowing your account. This does not mean you buy 1% of your account worth of shares.
This means 1% risk at your predetermined exit point where the trade is wrong.
This is called position sizing. You can use the free position sizing calculator on the Trading Bases website to calculate how many shares you should buy to position size your trade at your chosen risk. When position sizing I use realized returns. The closed trades balance of the account. This is important as you don't want to be sizing on the unrealized portfolio balance as you will be taking oversized risk at the exact top of a market when the account is at its best.
When deciding how much you will risk you must also take into account that losers can come in groups. The better your win rate is the smaller the groups of losers will be but nothing is set in stone. If you are trading too big and hit a run of losers you will have an overpowering pressure to lower your risk thus making the task of trading out of the hole twice the size.
The answer is not to trade too big in the first place. You must let your account growth raise your risk over time and only time will help you gradually get used to trading with bigger size. Everyone wants to take big bets and get rich quick but very few people who take that big bet have the psychology to hold it long enough to be a big winner. Most cut the winner short then take a couple of big losers to put themselves in a deep hole that they will never trade out of. Your twitter guru today will be gone tomorrow so if you want to stay in this game long enough to see your account start to grow then you need to start small. I traded my first few years risking 0.8% on a trade and limiting portfolio heat at stops to 8% of the account. After I fine tuned my method by taking less trades but better trades I moved my risk to 1% with 10% heat.
Here is a piece on position sizing I wrote for the website and it gives details of my own risk.
To be successful you need to build a degree of failure into your risk management. It doesn't matter if you are fundamental or technicals based. It doesn't matter if you call yourself an investor or a trader. The math of winning doesn't discriminate.
Before taking any trades you need a plan and the most important part of any trading plan is the risk management. It's your insurance policy against a global market sell off that doesn't care about the value of any of your holdings. Risk management is there to limit the losses when you make bad decisions or you didn't follow your rules. It's there to limit the size of the hole you have to trade out of after a draw down. Most of all it's there to protect you from the risk of ruin. If you want to be trading in the future you need to stay in the game long enough to see the future returns.
The suggestions that are made below are what I consider the low risk approach. Knowing when to take more risk on special trades or take more heat risk on the account are advanced techniques for traders who have the psychology to stomach larger risk.
This will come with time spent in the markets.
Two very important questions you need to answer are How Much Shall I Risk on Each Trade? and How Much Heat Will I Expose My Account To on Open Trades?
How Much Should I Risk on Each Trade?
1% = 100 trades away from blowing your account.
2% = 50 trades away from blowing your account.
3% = 33 trades away from blowing your account.
If you risk 1% on every trade you take you will always be 100 trades away from blowing your account. This does not mean you buy 1% of your account worth of shares.
This means 1% risk at your predetermined exit point where the trade is wrong.
This is called position sizing. You can use the free position sizing calculator on the Trading Bases website to calculate how many shares you should buy to position size your trade at your chosen risk. When position sizing I use realized returns. The closed trades balance of the account. This is important as you don't want to be sizing on the unrealized portfolio balance as you will be taking oversized risk at the exact top of a market when the account is at its best.
When deciding how much you will risk you must also take into account that losers can come in groups. The better your win rate is the smaller the groups of losers will be but nothing is set in stone. If you are trading too big and hit a run of losers you will have an overpowering pressure to lower your risk thus making the task of trading out of the hole twice the size.
The answer is not to trade too big in the first place. You must let your account growth raise your risk over time and only time will help you gradually get used to trading with bigger size. Everyone wants to take big bets and get rich quick but very few people who take that big bet have the psychology to hold it long enough to be a big winner. Most cut the winner short then take a couple of big losers to put themselves in a deep hole that they will never trade out of. Your twitter guru today will be gone tomorrow so if you want to stay in this game long enough to see your account start to grow then you need to start small. I traded my first few years risking 0.8% on a trade and limiting portfolio heat at stops to 8% of the account. After I fine tuned my method by taking less trades but better trades I moved my risk to 1% with 10% heat.
Here is a piece on position sizing I wrote for the website and it gives details of my own risk.
The chart above highlights some very important information about the probability of a string of successive losing trades in a row. I've highlighted in yellow the closest calculations to a coin flip of 50% or slightly above.
What does this mean?
If you have a 30% win rate it is possible to have 10 losers in a row. In fact it is possible to have more than 10 losers in a row but a 55% chance is basically a coin flip. If you risked 3% of your account on each trade you will be 30% in a hole and now need to make 43% just to get your account back to break even. Losses work exponentially against you. The more heat you risk your open positions to the harder it will be to trade out of the hole when that string of losers eventually comes along.
If you have a 30% win rate and risked 1% of your account on each trade you will be 10% in a hole and it will take 11.1% to get back to break even. This is easily achievable. Remember this is assuming you have an approach that is profitable with a 30% win rate. In reality good market conditions will give higher win rates, choppy grinding markets will give average win rates and bad markets will give low win rates. This is normal.
Runs of Losers
Below left is the realized equity curve of my UK smallcap account from 2019. Going back to October 2018 I actually closed 12 losers in a row. We were knocking it out of the park before the correction in 2018 and then along came a correction. I managed my trades as usual by basically letting the weak stocks hit the trailing stop designed to capture the primary trend and strong stocks that held up through the correction survived to trend higher into 2019. To the untrained eye it might look awful. It tapered off until week 38 where closing two trades brought it back up to all time high's. This means as I risk 1% of account per trade the next trade I took would be the highest 1% ££££ risk the account had ever traded on.
Ride Your Winners, Cut Your Losers.
I could have managed the market environment very differently to smooth out that losing curve by selling some winners but my style is to capture the primary trend in small caps so if I pick tops in my trending stocks I will never capture the mother of all trends period. If you are true to riding your winners then losers will naturally come in groups especially in a tough market environment but if you look at the unrealized gains equity curve below right the account was grinding sideways and closing the two trades that brought my risk back to new high's helped fuel a run in the portfolio that started in September and built up a head of steam in October ignoring all election and brexit news. The cash from the closed trades and the higher risk per trade did two things. It let me add more to my current stocks that traded add points and it let me take more trades that were emerging. So why did the move start so late in the year when fully invested accounts were feeling the love from the lows in 2018? I only buy strong stocks and the trend following style naturally has to wait for the stocks to emerge. Not bounce. The reality of having exits on weak stocks in a correction will hold an account drawdown nearer to all time high's leaving less work to do to break those high's and avoiding that occasion when the market keeps going lower into the realms of the 50% drawdown. The next one is always ahead of us and I personally am not taking that ride. Heat is my limiter that protects me from that scenario.
What does this mean?
If you have a 30% win rate it is possible to have 10 losers in a row. In fact it is possible to have more than 10 losers in a row but a 55% chance is basically a coin flip. If you risked 3% of your account on each trade you will be 30% in a hole and now need to make 43% just to get your account back to break even. Losses work exponentially against you. The more heat you risk your open positions to the harder it will be to trade out of the hole when that string of losers eventually comes along.
If you have a 30% win rate and risked 1% of your account on each trade you will be 10% in a hole and it will take 11.1% to get back to break even. This is easily achievable. Remember this is assuming you have an approach that is profitable with a 30% win rate. In reality good market conditions will give higher win rates, choppy grinding markets will give average win rates and bad markets will give low win rates. This is normal.
Runs of Losers
Below left is the realized equity curve of my UK smallcap account from 2019. Going back to October 2018 I actually closed 12 losers in a row. We were knocking it out of the park before the correction in 2018 and then along came a correction. I managed my trades as usual by basically letting the weak stocks hit the trailing stop designed to capture the primary trend and strong stocks that held up through the correction survived to trend higher into 2019. To the untrained eye it might look awful. It tapered off until week 38 where closing two trades brought it back up to all time high's. This means as I risk 1% of account per trade the next trade I took would be the highest 1% ££££ risk the account had ever traded on.
Ride Your Winners, Cut Your Losers.
I could have managed the market environment very differently to smooth out that losing curve by selling some winners but my style is to capture the primary trend in small caps so if I pick tops in my trending stocks I will never capture the mother of all trends period. If you are true to riding your winners then losers will naturally come in groups especially in a tough market environment but if you look at the unrealized gains equity curve below right the account was grinding sideways and closing the two trades that brought my risk back to new high's helped fuel a run in the portfolio that started in September and built up a head of steam in October ignoring all election and brexit news. The cash from the closed trades and the higher risk per trade did two things. It let me add more to my current stocks that traded add points and it let me take more trades that were emerging. So why did the move start so late in the year when fully invested accounts were feeling the love from the lows in 2018? I only buy strong stocks and the trend following style naturally has to wait for the stocks to emerge. Not bounce. The reality of having exits on weak stocks in a correction will hold an account drawdown nearer to all time high's leaving less work to do to break those high's and avoiding that occasion when the market keeps going lower into the realms of the 50% drawdown. The next one is always ahead of us and I personally am not taking that ride. Heat is my limiter that protects me from that scenario.
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Diversified or Concentrated?
The age old question of diversification or concentration needs to be addressed when it comes to running a portfolio so here's a few pointers for you to think about. I risk 1% of my realized account per trade. A trade is sized by the bracket needed in the stock I'm trading. The bracket is the entry minus the exit. I size so the exit will be 1% of my account on a full loser. Different brackets will give different portfolio weightings. Volatile stocks will have wider brackets and naturally it results in lower weightings. The aim is to become concentrated in your best stocks. The only way to do this safely is to take a sensible weighting by position sizing on entry and the stocks that let you add and continue to trend will become concentrated stocks in the account. Those that don't move or underperform will still have their original weightings and as the account grows these underperformers will have little effect on the portfolio volatility. Concentrated is the goal but in reality the account is diversified apart from the best holdings that gradually become concentrated through adding more in the early stages of the stock trending higher and through price appreciation. Achieving concentration means your stocks and the markets are in good form. Adding to your winner and achieving a concentrated position in a trending stock is the safe way to make the biggest gains. Here's the scenario. You ride a big winner up hundreds of percent then you get hit by the worst profit warning and give back 50%. Well its not going to feel good giving back some gains but you bank a huge winner all the same, compound the account and move on. Scenario 2. You split your account 10 ways and buy 10% weightings. You lose 5% overnight in a 50% profit warning or worse still you time the market badly and lose over 20% of the portfolio during a normal 10% market correction. Small caps tend to be twice the volatility of the general market. Scenario one is compounding gains and giving back the tail and anyone who trails a stop gives back the tail. Scenario 2 is trading the account into a hole that could end up so deep that its near impossible to trade back out of. You cannot limit the drawdown heat or protect the account from gap risk using Scenario 2. Concentration should be earn't. It shouldn't be treated like a flippant get rich quick solution. It isn't. Some get lucky. Many more blow up.
Why Is Limiting Heat So Important?
When that bear market comes around you will need to be out of the market if you want to be able to trade the start of the next bull market. If you stay invested through a bear market on average it takes about six years to recover. At the shortest it takes two or three years and at the longest it takes eight or nine years.
If you're fully invested then you are out of the game until the markets recover. Now before you throw all the Warren Buffet quotes at me hear me out. Berkshire Hathaway lost over 50% of its value in 2008 and took four years to recover. That adds up to over five years of pain for those who bought just before the drop. There is no "but if" that can change the simple math involved. If you need to trade in a bear market the short side is the path of least resistance. If you only like to trade the long side then take a holiday and enjoy life for a while. That’s what we trade for. To have the freedom to enjoy life more and a bear market will give you at least one year to do just that. Make the most of it.
How Much Heat Will I Expose My Account to on Open Positions?
The sweet spot for portfolio heat is 10%. If you're adding trades and they are not moving in your favour there is no point in exposing your account to more risk by taking on more heat than your win rate can handle. If your strategy is underperforming then the market is telling you something. It doesn't mean your proven strategy is failing (This can lead to style drift and the endless search for the holy grail trading method). Sometimes the markets just don't want to behave how you'd like them to.
Portfolio Heat Draw Downs
-5% = 5.3% back to break even
-10% = 11.1% back to break even
-20% = 25% back to break even
-50% = 100% back to break even
As you see from the examples above the more heat you expose your account to the harder it will be to trade out of the hole. Once you let your account fall 50% you will have the huge task of doubling your account just to get back to break even and that’s before trading costs.
You need to eliminate the risk of having to trade yourself out of a big hole. Limiting your heat on open positions will stop you taking too much risk. As positions move in your favour and you lock in some gains by trailing stops you will free up more heat. You are now adding positions when trades are working and your risk is limited when trades are chopping around or moving against you.
At 1% Risk. Ten losers in a row would be 10% Heat.
At 2% Risk. Five losers in a row would be 10% Heat
At 3% Risk. Four losers in a row would be 12% Heat.
A 30% win rate needs to be traded at 1% max risk to limit heat on 10 Losers
A 40% win rate needs to be traded at 1.4% max risk to limit heat on 7 Losers
A 50% win rate needs to be traded at 2% max risk to limit heat on 5 Losers
A 60% win rate needs to be traded at 3% max risk to limit heat on 3 Losers
Know Your Win Rate
If you don't know your win rate for your own style of trading you should start working on it now. Go through all your history and work it out. If you're new to trading and are working on a systematic rules based approach you will need to back test and then forward test your method over at least 50 trades to get a ball park win rate figure. 50 back tested then 50 forward tested. Knowing your win rate will help you blend your risk and heat to your own style of trading.
You could drop all your trades into the spreadsheet we supply if you're a member.
If you choose to forward test with real money then trade at the smallest level you can. It's not about the money. It's about the process. You don't want to get skewed results because you traded too big and didn't follow your rules. Don't worry about the trading costs of trading too small. There is a price to learning. For most people it costs them their whole trading account. Some of the best traders in the world got through two or more accounts before they figured it out. For a few wise people who actually want to learn by trading small until they prove they can make money it will just cost them in trading fees meaning if you trade at a very small size your trading fees could be the difference between a winning system and a losing system.
Fools Rush In
The market will always be there. It's better to be late with more funds saved up while you're testing your approach than jumping straight in with a small account and watch it get smaller. A high percentage of people who read this already have accounts that are in draw downs from when they started. That money has flowed into the accounts of the professionals who use risk management. If you want to join the professionals you need to get your own risk management up to the same standards.
Next Tutorial - The steps to Profit Blueprint
Jase @stealthsurf
The age old question of diversification or concentration needs to be addressed when it comes to running a portfolio so here's a few pointers for you to think about. I risk 1% of my realized account per trade. A trade is sized by the bracket needed in the stock I'm trading. The bracket is the entry minus the exit. I size so the exit will be 1% of my account on a full loser. Different brackets will give different portfolio weightings. Volatile stocks will have wider brackets and naturally it results in lower weightings. The aim is to become concentrated in your best stocks. The only way to do this safely is to take a sensible weighting by position sizing on entry and the stocks that let you add and continue to trend will become concentrated stocks in the account. Those that don't move or underperform will still have their original weightings and as the account grows these underperformers will have little effect on the portfolio volatility. Concentrated is the goal but in reality the account is diversified apart from the best holdings that gradually become concentrated through adding more in the early stages of the stock trending higher and through price appreciation. Achieving concentration means your stocks and the markets are in good form. Adding to your winner and achieving a concentrated position in a trending stock is the safe way to make the biggest gains. Here's the scenario. You ride a big winner up hundreds of percent then you get hit by the worst profit warning and give back 50%. Well its not going to feel good giving back some gains but you bank a huge winner all the same, compound the account and move on. Scenario 2. You split your account 10 ways and buy 10% weightings. You lose 5% overnight in a 50% profit warning or worse still you time the market badly and lose over 20% of the portfolio during a normal 10% market correction. Small caps tend to be twice the volatility of the general market. Scenario one is compounding gains and giving back the tail and anyone who trails a stop gives back the tail. Scenario 2 is trading the account into a hole that could end up so deep that its near impossible to trade back out of. You cannot limit the drawdown heat or protect the account from gap risk using Scenario 2. Concentration should be earn't. It shouldn't be treated like a flippant get rich quick solution. It isn't. Some get lucky. Many more blow up.
Why Is Limiting Heat So Important?
When that bear market comes around you will need to be out of the market if you want to be able to trade the start of the next bull market. If you stay invested through a bear market on average it takes about six years to recover. At the shortest it takes two or three years and at the longest it takes eight or nine years.
If you're fully invested then you are out of the game until the markets recover. Now before you throw all the Warren Buffet quotes at me hear me out. Berkshire Hathaway lost over 50% of its value in 2008 and took four years to recover. That adds up to over five years of pain for those who bought just before the drop. There is no "but if" that can change the simple math involved. If you need to trade in a bear market the short side is the path of least resistance. If you only like to trade the long side then take a holiday and enjoy life for a while. That’s what we trade for. To have the freedom to enjoy life more and a bear market will give you at least one year to do just that. Make the most of it.
How Much Heat Will I Expose My Account to on Open Positions?
The sweet spot for portfolio heat is 10%. If you're adding trades and they are not moving in your favour there is no point in exposing your account to more risk by taking on more heat than your win rate can handle. If your strategy is underperforming then the market is telling you something. It doesn't mean your proven strategy is failing (This can lead to style drift and the endless search for the holy grail trading method). Sometimes the markets just don't want to behave how you'd like them to.
Portfolio Heat Draw Downs
-5% = 5.3% back to break even
-10% = 11.1% back to break even
-20% = 25% back to break even
-50% = 100% back to break even
As you see from the examples above the more heat you expose your account to the harder it will be to trade out of the hole. Once you let your account fall 50% you will have the huge task of doubling your account just to get back to break even and that’s before trading costs.
You need to eliminate the risk of having to trade yourself out of a big hole. Limiting your heat on open positions will stop you taking too much risk. As positions move in your favour and you lock in some gains by trailing stops you will free up more heat. You are now adding positions when trades are working and your risk is limited when trades are chopping around or moving against you.
At 1% Risk. Ten losers in a row would be 10% Heat.
At 2% Risk. Five losers in a row would be 10% Heat
At 3% Risk. Four losers in a row would be 12% Heat.
A 30% win rate needs to be traded at 1% max risk to limit heat on 10 Losers
A 40% win rate needs to be traded at 1.4% max risk to limit heat on 7 Losers
A 50% win rate needs to be traded at 2% max risk to limit heat on 5 Losers
A 60% win rate needs to be traded at 3% max risk to limit heat on 3 Losers
Know Your Win Rate
If you don't know your win rate for your own style of trading you should start working on it now. Go through all your history and work it out. If you're new to trading and are working on a systematic rules based approach you will need to back test and then forward test your method over at least 50 trades to get a ball park win rate figure. 50 back tested then 50 forward tested. Knowing your win rate will help you blend your risk and heat to your own style of trading.
You could drop all your trades into the spreadsheet we supply if you're a member.
If you choose to forward test with real money then trade at the smallest level you can. It's not about the money. It's about the process. You don't want to get skewed results because you traded too big and didn't follow your rules. Don't worry about the trading costs of trading too small. There is a price to learning. For most people it costs them their whole trading account. Some of the best traders in the world got through two or more accounts before they figured it out. For a few wise people who actually want to learn by trading small until they prove they can make money it will just cost them in trading fees meaning if you trade at a very small size your trading fees could be the difference between a winning system and a losing system.
Fools Rush In
The market will always be there. It's better to be late with more funds saved up while you're testing your approach than jumping straight in with a small account and watch it get smaller. A high percentage of people who read this already have accounts that are in draw downs from when they started. That money has flowed into the accounts of the professionals who use risk management. If you want to join the professionals you need to get your own risk management up to the same standards.
Next Tutorial - The steps to Profit Blueprint
Jase @stealthsurf