Taming Risk
By Norman Hallett - The Disciplined Trader
This is an extract from "Managing Risk", a trading guide by Norman Hallett.
General Rules For Money Management And Capital Preservation
1. Risk only a small percentage of total equity on each trade, preferably no more than 2% of your portfolio value.
2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on every open position in your account at the same time, you would still retain 80% of your original trading capital.
3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points.
4. Be realistic about the amount of risk required to properly trade a given market. For instance, don't kid yourself by thinking you are only risking a small amount if you are position trading (holding overnight) in a high-flying technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust position size accordingly. That is, take smaller positions in more volatile stocks and futures. Also, be aware that volatility is constantly changing as markets heat up and cool off.
6. Understand position correlation. If you are long heating oil, crude oil and unleaded gas, in reality you do not have three positions. Because these markets are so highly correlated (meaning their price moves are very similar), you really have one position in energy with three times the risk of a single position. It would essentially be the same as trading three crude, three heating oil, or three unleaded gas contracts.
7. Lock in at least a portion of windfall profits. If you are fortunate enough to catch a substantial move in a short amount of time, liquidate at least part of your position. This is especially true for short-term trading, for which large gains are few and far between.
8. The more active a trader you are, the less you should risk per trade. Obviously, if you are making dozens of trades a day you can't afford to risk even 2% per trade--one really bad day could virtually wipe you out. Longer-term traders who may make three to four trades per year could risk more, say 3-5% per trade. Regardless of how active you are, just limit total portfolio risk to 20% (rule #2
9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading. However, if there was one, I think it would be having enough money to trade and taking small risks. These principles help you survive long enough to prosper. I know of many successful traders who wiped out small accounts early in their careers. It was only until they became adequately capitalized and took reasonable risks that they survived as long term traders
10. Never add to or "average down" a losing position. If you are wrong, admit it and get out. Two wrongs do not make a right.
11. Avoid pyramiding altogether or only pyramid properly. By "properly," I mean only adding to profitable positions
12. Always have an actual stop in the market. "Mental stops" do not work.
13. Be willing to take money off the table as a position moves in your favor; "2-for-1 money management1" is a good start. Essentially, once your profits exceed your initial risk, exit half of your position and move your stop to breakeven on the remainder of your position. This way, barring overnight gaps, you are ensured, at worst, a breakeven trade, and you still have the potential for gains on the remainder of the position.
14. Understand the market you are trading. This is especially true in derivative trading (i.e. options, futures).
15. Strive to keep maximum drawdown between 20 and 25%. Once drawdown exceeds this amount it becomes increasingly difficult, if not impossible, to completely recover
16. Be willing to stop trading and re-evaluate the markets and your methodology when you encounter a string of losses.
17. Consider the psychological impact of losing money. Unlike most of the other techniques discussed here, this one can't be quantified. Obviously, no one likes to lose money. However, each individual reacts differently. You must honestly ask yourself, What would happen if I lose X%? Would it have a material effect on my lifestyle, my family or my mental well being? You should be willing to accept the consequences of being stopped out on any or all of your trades. Emotionally, you should be completely comfortable with the risks you are taking
2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on every open position in your account at the same time, you would still retain 80% of your original trading capital.
3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points.
4. Be realistic about the amount of risk required to properly trade a given market. For instance, don't kid yourself by thinking you are only risking a small amount if you are position trading (holding overnight) in a high-flying technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust position size accordingly. That is, take smaller positions in more volatile stocks and futures. Also, be aware that volatility is constantly changing as markets heat up and cool off.
6. Understand position correlation. If you are long heating oil, crude oil and unleaded gas, in reality you do not have three positions. Because these markets are so highly correlated (meaning their price moves are very similar), you really have one position in energy with three times the risk of a single position. It would essentially be the same as trading three crude, three heating oil, or three unleaded gas contracts.
7. Lock in at least a portion of windfall profits. If you are fortunate enough to catch a substantial move in a short amount of time, liquidate at least part of your position. This is especially true for short-term trading, for which large gains are few and far between.
8. The more active a trader you are, the less you should risk per trade. Obviously, if you are making dozens of trades a day you can't afford to risk even 2% per trade--one really bad day could virtually wipe you out. Longer-term traders who may make three to four trades per year could risk more, say 3-5% per trade. Regardless of how active you are, just limit total portfolio risk to 20% (rule #2
9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading. However, if there was one, I think it would be having enough money to trade and taking small risks. These principles help you survive long enough to prosper. I know of many successful traders who wiped out small accounts early in their careers. It was only until they became adequately capitalized and took reasonable risks that they survived as long term traders
10. Never add to or "average down" a losing position. If you are wrong, admit it and get out. Two wrongs do not make a right.
11. Avoid pyramiding altogether or only pyramid properly. By "properly," I mean only adding to profitable positions
12. Always have an actual stop in the market. "Mental stops" do not work.
13. Be willing to take money off the table as a position moves in your favor; "2-for-1 money management1" is a good start. Essentially, once your profits exceed your initial risk, exit half of your position and move your stop to breakeven on the remainder of your position. This way, barring overnight gaps, you are ensured, at worst, a breakeven trade, and you still have the potential for gains on the remainder of the position.
14. Understand the market you are trading. This is especially true in derivative trading (i.e. options, futures).
15. Strive to keep maximum drawdown between 20 and 25%. Once drawdown exceeds this amount it becomes increasingly difficult, if not impossible, to completely recover
16. Be willing to stop trading and re-evaluate the markets and your methodology when you encounter a string of losses.
17. Consider the psychological impact of losing money. Unlike most of the other techniques discussed here, this one can't be quantified. Obviously, no one likes to lose money. However, each individual reacts differently. You must honestly ask yourself, What would happen if I lose X%? Would it have a material effect on my lifestyle, my family or my mental well being? You should be willing to accept the consequences of being stopped out on any or all of your trades. Emotionally, you should be completely comfortable with the risks you are taking
Successful trader depends largely on understanding the ways to identify and control risk. It is not about timing the big move or being a home run hitter. Is about risking only a small percentage on any one trade and keeping total risk exposure within pre-determined limits.
