Risk Management

Many traders are constantly looking for the Holly Grail system that is going to make them filthy rich. Well, you have just found it. It is called risk management. Even if your equity selection method is  has the success rate of a coin flip, a disciplined risk management approach will make you consistently profitable. It is that important.

To establish a working Risk Management method, you need to understand and comprehensively investigate the following topics:

1. Defining your trading goal in terms of risk taken to achieve certain return: if you risk $1 in order to make $1, you won’t get far in the trading or the investing business. Focus on ideas with at least 3:1 reward to risk ratio. While finding high reward/low risk set ups sounds good on paper, in practice the only thing that you can control from the very beginning is your stop loss. You are the one to decide where to cut losses short, but the market is the one that will decide how long a trend will continue.

It is indisputable that once you see your position in the green, it is in your hands to decide when and how to exit. Premature exits are as bad for your long-term performance as not cutting your losses short. In real life about 20% of your trading/investing ideas are likely to account for 80% or more of your profits. You have to make sure that you make a lot of money when you are right by entering partially and building a bigger position as you leverage up. Exits are also extremely important. You cannot hope to sell at the absolute top. Even if by some accident that happens, on the top there’s just not enough liquidity. I tend to ladder my exit with 1/2 to 1/3 position at a time. It costs more in commissions, but ultimately provide better risk control and an opportunity to squeeze as much as you can from any position that you’ve taken. While it is good to have a target price in mind, be aware that your profits can erode in a blink of an eye. By taking partial profit when you have it and moving your stop loss to break-even for the remaining, you are reducing your risk aggressively. You will achieve much higher return by targeting five-six 10% gains in a month instead of being stubborn and shoot for 50% home run.

2.Position sizing and Defining R (% of your capital that you are willing to risk in every trade you take) : to define the size of your position you need to know what % of your capital are you going to consistently risk and where your stop loss for the trade will be located. I usually risk between 0.5% and 2% of my capital on any single trade that I take. Why is it so important to risk small percentage of your capital on any idea? The simplest and most honest answer to this question is that you actually have no clue if you are going to be right. You chose the set up with the best odds based on your experience and even when everything looks perfect, you might experience a loss. As some say (forgive me for my French) “Shit happens”. In addition to that, if you lose 1% of your capital per trade, you only need to gain 1.01% on your next trade to get back to break even. If you lose 10%, you need to make 11.11%. If you lose 20%, you need to make 25%.

Let assume that you would like to short a stock that is currently priced at $13. On the 30 min chart (or whatever you use), you figure out that 13.50 is a proper place to put your stop since it represents a potential level of strong resistance and if broken your initial argument to take the trade won’t exist any more. Therefore you are risking 50 cents per share in this case. If your capital is 100k and you risk 1% on all your trades, that means that you will be willing to risk 100k*1% = 1,000 on this one.

$1000/.50 = 2000 shares

2000 shares * $13 per share = $26,000 initial investment

3. Expectancy

• How often you are right?
• what is the average profit of your winning/losing trade

Expectancy = % of winning trades*average profit – % of losing trades*average loss

Profits and losses are measured in terms or R or % of capital that you risk per trade

For example if you are right 40% of the time and your average profit is 3R and average loss 1R, then the expectancy of your trading method is 0.4*3R – 0.6*1R = 0.6R, which means that after discounting all your winning and losing trades you are making 0.6R profit per every trade you take. If you make 200 trades per year using a method with 0.6R expectancy, your annual profit would be 200*0.6R = 120R.

You see that you don’t have to be right very often in order to make money consistently. What is important is to let your winners run, so you could have higher average profit per trade and cut your losses fast, so you could limit your average loss per trade. It is common sense, but not common practice.

4. Exit Rules

• stop loss
• trailing profit protection stop
• time stop

You have to know where you would exit your trade, before you initiate it. If you don’t know that in front, you have lost before you have even started. Without knowing where your stop loss is, it is much harder to define the size of your position in a disciplined, unbiased way and if you can’t do that, you better omit it. Having an exit is so important  that long time ago, I put a sign with the word “EXIT” on the wall above my desk. It is that essential. It is there to remind me to always have an exit plan in everything I do, not only trading.

Cutting losses short is the single most important move you could do as a trader. By doing that, you will be automatically ahead of 90% of the traders out there. I can’t stress enough how important it is to to lose cents on the dollar while trying to make several dollars. We, as human beings, are wired to desire to be right all the time and that makes us keep our losing positions longer than we have to in order to give them some time to recover, to at least break even. There is nothing more dangerous in the business of trading. You have to overcome your human weaknesses and be like a terminator with your losing trades: eliminate them fast. Understand that you would be occasionally shaken out by a fake move, only to see the stock reverse back in the desired direction. This will happen, but  it is not a reason not to respect your stop loss. Take your loss, see if you could learn something from it and continue with the next trade. If you can’t take small losses, sooner or later you will have to take the mother of all losses and you will be out of business.

5. The Opportunity factor: how many trading candidates does your system provide per week, per month, per year. Some systems provide 2-3 signals per year, but still could be very profitalble. Other systems provide thousands of opportunities every day. Find the one that best fits your skills, personality, capital and tools.

6. Market breath: There are times to be long, times to be short and times to go on vacation.

Losses are part of the trading/investing business, but they always bring a message with them. If you experience several losing trades in a row, despite diligently following a method with proven statistical edge, you know that something in the market has changed: the direction of the trend, the overall sentiment, the volatility. Changes that will require a change in your market approach. This could involve staying on the sidelines for a while, using wider stops and therefore smaller positions, shortening your trading horizon and cutting initial price targets.

I have noticed recently that when the SPY and QQQQ are below their declining 10 DMA, the majority of the ideas produced by my long momentum screens are getting faded. Perfectly good breakouts that in normal market circumstances go to make at least 15-20% moves, are quickly turning into losers. I decided that as long as major market averages are below their declining 10 DMA, I will stay on the sidelines and won’t initiate any new long momentum swing trades.

To measure investors sentiment, I use two ETFs – EEM (long emerging markets) and TLT (long US treasuries). Prices are moved by supply and demand. Supply and demand are determined by investors’ mood. When EEM is above its rising 10dma, there is risk appetite in the financial markets and the odds of profiting by going long equity are significantly higher. When TLT is rising above its 10dma, investors are in defensive mood and the odds of making money being short are higher.

Of course this is just my way to protect my capital and what suits my approach may not the the best solution for someone else. There are hundreds of different indicators that people use to measure market breath and their only purpose is to keep you out of the market, when the odds are against you. The success rate of any market approach is cyclical. It is your job to build a method that will help you to determine when to be aggressive and when to stay on the sidelines.