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 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 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 achievable.
Remember this is assuming you have an approach that is profitable with a 30% win rate.
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.
Jase @stealthsurf
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 achievable.
Remember this is assuming you have an approach that is profitable with a 30% win rate.
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.
Jase @stealthsurf