Often overlooked, risk management is one of the most important subjects for traders. In this article we’ll explore how to protect your capital and tilt the odds of success in your favour with key risk management strategies.
First of all we’ll look touch on the psychology of trading and an irrational human tendency. We’ll identify the behavior that is the most common cause behind people blowing out their accounts. Avoid this trait and you’ll be ahead of the majority of traders.
Behavioral Economics and Trading
Behavioral economists have shown that people inherently make irrational decisions when it comes to investing and trading.
In a classic study by Kahneman and Tversky, subjects were given a choice between a certain $3,000 gain versus an 80% chance of a $4,000 gain and a 20% chance of getting nothing.
A large majority chose the $3,000 gain.
The question was reversed and subjects were given a choice between a certain $3,000 loss versus an 80% chance of losing $4,000 and a 20% chance of losing nothing.
In this case the majority chose to take the 80% risk of losing $4,000 and 20% chance of losing nothing.
In both cases people made irrational choices from a mathematical perspective when calculating an expected win or loss.
The study relates to trading and investing in a profound way.
Jack Schwager, author of Market Sense and Nonsense sums it up as follows;
…the experiment reflects a quirk in human behavior in regards to risk and gain: people are risk averse when it comes to gains, but are risk takers when it comes to avoiding a loss. This behavioral quirk relates very much to trading and explains why people tend to let their losses run and cut their profits short.
Drawdowns are a peak-to-trough decline during a specific recorded period in your trading. Losing trades are an inevitable part of trading. Even if you have a strategy that has an 80% success rate, you could start out with a succession of losing trades. With proper risk management in place you will be able to survive the drawdowns and be consistently profitable over the long term.
The 2 percent rule is a widely held concept in money management.
The 2% rule states that you should never risk more than 2% of your account equity on a single trade.
Market Wizard Larry Hite “Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade.”
When you use the 2% rule, you should be able to survive a substantial drawdown. If you were risking 10% of your capital on each trade you could very easily wipe out your brokerage account with a series of losing trades.
The 6% rule presented by Alexander Elder in ‘Come into my Trading Room’ states that if the value of your account falls 6% below it’s closing value the prior month you should stop trading for the rest of the month.
Recovering Lost Equity
When you lose money in trading the percentage of your return on your remaining capital to recover your lost equity is shockingly high.
Consider the following percentages required to recover from significant percentage losses in your account:
- A 25% equity Loss requires a 33% return to recover former equity value.
- A 50% Equity loss requires a 100% return to recover former equity value.
- A 75% Equity loss requires a 400% return to recover former equity value.
As you lose more, it becomes increasingly hard in percentage terms to recover to break-even. This underscores why it’s so important to manage your risk.
Conventional wisdom states that if you give yourself a reward target greater than your risk allowance, you increase your chances of being profitable in the long run. For example a ratio of 3:1: in this instance your stop loss could be at 10 pips and your profit target at 30 pips or for a longer term trade a stop loss of 100 pips and profit target of 300 pips.
Short term traders need to keep in mind that you need to pay the spread just to get into the trade, which is significant if your stop loss and profit targets are relatively small.
The Kelly Criterion
The Kelly Criterion was originally developed by John Kelly while working for AT&T’s Bell Laboratory. When the method was published in 1956 it was first used by the gambling community, and later regarded as an effective money monagement tool by the investing community.
The Kelly Criterion looks at two major inputs:
W – The probability that a given trader/system will be a winner.
R – The Win/Loss Ratio – amount gained from winning trades divided by amount lost from losing trades.
The Kelly percentage is derived using these in an equation as follows:
Kelly % = W – [(1 – W) / R]
The Kelly percentage is used to show your optimal position size. For example a Kelly percentage of 0.08 suggests that you should take an 8% position in the securities in your portfolio.
In gambling the formula dictates the percentage of capital to be bet at each iteration of the game. Kelly’s formula was used by Dr. Edward O. Thorp, both in blackjack and in the stock market.
Thorp, author of the classic Beat the Dealer book has been cited as one of the most consistently profitable money managers. As a hedge fund manager for over 28 years, Dr. Thorp achieved an unprecedented 20% return per year.
The Kelly Criterion assumes that you are using a consistent set of trading rules.
The system helps you limit your losses and maximize your gains through efficient diversification.
The Kelly Capital Growth Investment Criterion by Leonard C. MacLean provides an in depth study.
Ralph Vince’s optimal-f method aims to show the optimal amount to risk on each trade to maximize profits – the amount of equity to risk on a given trade.
The idea is to determine the ideal amount of your capital to allocate per trade based on past performance. If your Optimal F is 7%, then each trade should be 7% of your account.
Ralph Vince analyzed many systems as computer programmer for Larry Williams, winner of the 1987 World Cup Championship of Futures Trading.
Optimal f Formula
Number of shares = (Optimal F * Current Capital / starting risk per unity of assets)/Security Price where starting risk = maximal loss at trade (in %).
The Martingale System
Martingale is a money management system where the size of investments continually increases after losses.
The principle behind the Martingale system is that statistically you cannot lose all the time, and therefore you should increase the amount allocated in investments, in anticipation of a future increase.
By continually increasing position size the theory hold that the trader will come out profitable. However, this assumes of course an unlimited supply of capital.
The Anti Martingale System is the inverse of the above where more risk is taken after profits and risk is tapered after losses.
Stop Loss Strategies
There are a number of different ways to approach the use of stop loss orders as part of a money management strategy:
- Equity Stop Here the trader risks a fixed percentage of their equity on a trade and uses this to determine the placement of the stop loss order.
- Chart Stop This technique uses technical analysis such as support and resistance levels to determine the position of the stop loss order.
- Volatility Stop This method uses volatility as a measure of where to place the stop loss order – in a highly volatile market the loss should be wider and in a lower volatility setting the stop should be tighter. Average True Range (ATR) is one of the best known indicators for measuring volatility.
Position Sizing in the Turtle Trading System
The Turtles used a volatility based constant percentage risk position sizing algorithm. See this thread for more information on the Turtle Trading System.
Jeff Quinto on Money Management
Jeff Quinto’s career spanned being a floor trader, an executive at a major brokerage company, and co-founder of a proprietary trading firm. He has some great insights from his experience which he shares in a presentation titled ‘How a professional handles his trading capital’ given at the Chicago Mercantile Exchange. Watch it here: Jeff Quinto Presentation at CME
Use the 2% and 6% rules as ‘circuit breakers’. If you lose these set amounts in a day or a month, simple shut everything down in order to reevaluate. Drawdowns are inevitable, but with proper risk management and a good trading strategy you can view yourself as the casino owner – occasionally you will have to make payouts but over the long term you reap profits from the majority of your trades by having the odds tilted in your favour.