Risk management Strategies For Part Time Trading

Risk & Money Management for Part-Time Trading

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MasterTrader


http://mastertrader.online/tms_harmonics_ph/


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Any discussion of trading must include the topic of risk. It is risk, or rather the misunderstanding and misapplication of it, that most often trips up new traders, preventing them from ever becoming old traders.

As in any other part of life, you have to be prepared to face a negative to be able to achieve a significant positive. We take risks in our lives all the time. We generally do so in a fairly controlled fashion, though, with a degree of surety as to the outcome. Trading should be the same. Unfortunately, it often does not end up being that way.

Risk, in trading parlance, is defined by many people in the markets as the chance of a negative outcome taking place. It is often thought of in terms of losing money on a single trade or position, but it just as well can be applied to the aggregate of a collection of trades – one’s performance over time. Actually, it is the latter idea that should be the one you focus on most.

To be sure, trading involves risk, but as we already stated, you must take risk to gain reward. That is the simple fact. Do you need to take big risks, though, to achieve the big rewards the markets can provide? Not necessarily. While true in general terms that you need to take more risk to achieve higher returns, there is a limit. Taking maximum risk does not directly lead to maximum returns.

Consider this example.

You have a trading methodology with a 90% chance of producing a profit on any given trade. That sounds pretty good, doesn’t it?

Now let us say that the system produces an average per trade return equal to ten times the risk taken, so if you put 10% of your money in to a trade, you make 100%. That is a 10:1 reward/risk ratio, which is pretty fantastic.

So we have this awesome system which seems guaranteed to make us loads of money. It’s almost a sure thing!

It’s not a sure thing, though. If you were foolish enough to put all of your money in the trade each time out thinking that you need to risk the most to make the most, you would basically guarantee that you go bust.


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Why?

Because a 90% win rate is not 100%. You will eventually have a loser, and once you do you are done. You may have made tens of thousands on your trades to that point, but one loser would erase all of that. In fact, if you do enough trades you are almost assured of having a streak of 3-4 losers in a row. So even if you said, “well I’ll just cut my per trade risk in half to 50%” you are still probably going to end up wiping out your portfolio at some point.

The point here is that every trade you make comes with a risk that you lose money. No system or method is perfect. You will hit losers, and probably losing streaks. That is the risk of trading. Money management is the process you use to minimize the damage those losing trades and/or streaks have on your portfolio while also maximizing the gains you make over time.

This part of trading is what differentiates those who are long-term performers and those who are flashes in the pan. Anyone can pick a good trade or two, come up with a decent trading system, and all that. It’s the ones who master risk and money management who enjoy longevity in the markets.

Risk Tolerance

We mentioned the topic of risk tolerance earlier. Before you can properly outline a meaningful risk or money management strategy you first have to understand and define your personal risk tolerance. Some people are naturally risk-averse. They will tend to only feel comfortable exposing small amounts of their portfolio to the potential for loss. Others are more risk-tolerant and can stomach wilder portfolio swings.

Much goes in to the tolerance determination – age, income, life situation, personality – but the central point is that your risk management strategy must take everything into consideration. Risk tolerance goes a long way toward determining the manner in which you can operate. Once it is understood, the other elements discussed in this chapter will fall in to place.

You need a way to define your risk tolerance so that you can use it later on as you develop your money management scheme. The best way to do so is in terms of a percentage of your portfolio.

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Think two ways. The first is in terms of a single trade. How much of your portfolio can you lose on a single trade before starting to get squeamish. The second angle in defining risk tolerance is in terms of what is generally referred to as portfolio drawdowns. A drawdown is the distance (measured in % or account/portfolio value terms) from an equity peak to the lowest point immediately following it.

For example, say your portfolio rose from $10,000 to $15,000, fell to $12,000, then rose to $20,000. The drop from the $15,000 peak to the $12,000 trough would be considered a drawdown, in this case of $3000 or 20%.

You must determine – in percentage terms - how large a drawdown you are willing to accept. It is very much a risk/reward decision.

Low Drawdown Equity Curve

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On one extreme are trading systems with very, very small drawdowns, but also with low returns (low risk – low reward), making for a smooth equity curve (the plot of your portfolio value over time). On the other extreme are the trading systems with large returns, but similarly large drawdowns (high risk – high reward). They have more jagged equity curves.

Of course, every trader’s dream is a trading system or method with high returns and small drawdowns. Unfortunately, reality is often somewhere in between.


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High Drawdown Equity Curve

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Loss Recovery

You may be wondering at this point why all this matters if high returns are the overall objective. Shouldn’t we just accept any size drawdown so long as the total returns in the end are good?

That all sounds well and good, but it does not take in to account several important factors. The first is the fact that the more your account value falls, the bigger the return required to make up that loss. The chart below shows this very clearly.

Notice how fairly small drawdowns only require small gains to be made back. For example, a 10% drawdown requires only about an 11% return to recover the portfolio’s value (10% lost divided by 90% remaining value = 11.11%).

As the drawdowns get larger, though, the required gain to get back up to breakeven accelerates rapidly. For example, a 50% loss in your portfolio value means you would have to make 100% just to make back the lost funds (50% lost divided by 50% remaining value = 100%).

Because large drawdowns mean that large returns are required to bring your account value back up to its starting point, they also tend to mean long periods between equity peaks. This is an extremely important consideration in understanding and then defining your risk tolerance.

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Return Required to Make Backa Given % Loss

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As a part-time trader, you probably operate on a more extended timescale than is true for more active types of traders. That means you will take longer to recover from a significant decline in portfolio value. This is an important factor in your money management strategy. Be sure it is reflected as you plan things out.

Additionally, the combination of sharp drops your portfolio’s value and lengthy time spans making the money has the potential to be emotionally destabilizing. That can lead to you abandoning your trading system or methodology at exactly the wrong time.

In short, you must be able to accept the drawdowns likely to occur


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in your trading account’s value. You have to take that into consideration as you define the percent that represents your risk tolerance, both for single trade drops and portfolio value declines as the result of difficult spells. This is the high level starting point for your risk and money management strategy.

Risk of Ruin

You will sometimes come across the concept of Risk of Ruin (RoR) in discussions of risk management and trading system evaluation. Simply stated, the RoR is the chance of blowing out your account. Each of us has a different idea of what exactly that means, so the RoR will vary from trader to trader.

For example, assuming two traders use the same trading system in the exact same manner, the trader who considers “ruin” to be losing 50% of the account or portfolio value, would have a higher RoR than the one who views “ruin” as meaning a 75% loss. After all, it is less likely that you will lose 75% than 50% (at least we hope so!).

The RoR is mostly discussed when evaluating trading methods, but is tied very closely to risk and money management strategy. The more you are putting at risk on a per trade basis, the higher your RoR is going to be, all other things being equal. Other factors which contribute to the RoR determination are win rates and average win vs. average loss figures.

We are not going to spend much time with RoR, however we want to present it at this stage, because it does tie in with our earlier talk about per trade risk and how even a system with a high win rate can still result in bad results if too much risk is taken. It also goes hand-in-hand with the drawdown. After all, ruin is the worst kind of drawdown.

Timeframe & Trade Frequency

An important factor to keep in mind when determing your per trade risk and defining other factors in your money management scheme is how frequently you trade. That is tied in with your timeframe.

Generally speaking, those with shorter trading timeframes will make more trades over a given span. Someone doing daily market

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analysis, after all, is going to identify more trading opportunities than one only doing weekly analysis.

The question then can be framed in terms of time. How large a loss would you be fine taking over a given timeframe? For the sake of this discussion, we will use a year, but you can certainly pick a timeframe more to your liking.

For the sake of argument, we will say that we can tolerate a 25% drop in portfolio value over the course of a year. With that in mind, we can look at things from the perspective of three different trade frequencies – daily, weekly, and monthly.

We will say that the day trader makes about 200 trades per year (accounting for time off and days when no trades are done). The weekly trader does about 50 trades a year, and the monthly trader puts on a dozen trades.

Take a look at the table which follows. It outlines how frequently consecutive losing trades can be expected to happen given the number of trades done for each timeframe. The figures are based on an assumption of a 50% win rate.

Day Week Month Trades/Yr 200 50 12

Likelihood of a Run of Losses 3 Loss 100% 99% 55% 5 Loss 96% 46% 13% 7 Loss 61% 16% 3% 10 Loss 1% 0% 0%

The information in the table above is handy in that it can be put to direct use as we decide on our per trade risk. We know that for the day trader it is almost assured that there will be at least one run of 5 straight losing trades each year, and quite likely that there will be at least one run of seven straight losses.

This means that if we are trading that frequently, and do not want to get down more than 25% on our portfolio, we want to risk less than about 3.5% per trade (25% divided by 7 trades). In fact, if we put our risk at the 2.5% level, we are almost assured that we


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will not hit our 25% drawdown point (10 x 2.5%).

Using that same thinking, the implication is that we could take on more risk on a per trade basis. For example, we might be willing to accept a 16% chance of a 25% drawdown for weekly trading, so could base our per trade risk on a run of seven trades. That means about 3.5% risk per trade.

Similarly, at the monthly level, a 13% chance of a 5 loss run could be considered reasonable. We would then be willing to put 5% of our portfolio at risk for each trade.

Again, these figures are based on a 50% win rate, so basically a coin toss as to whether a trade is a winner or loser. Also note that the probabilities shown above are for at least one run of that length. There could be more than one. Also, you have to take in to consideration the fact that there could be two runs of losses sandwiching only one or two winning trades.

The actual risk of hitting our 25% risk point, therefore, is a bit higher than what the numbers in the above table suggest. That is in terms of chance, anyway. Keep in mind that we have not added the ratio of average winning trade to average losing trade in to the discussion. That can completely alter things.

The real RoR, if we consider 25% our Ruin point, goes way beyond just win rate. It takes in to account all the factors of exposure and return to come up with a probability. To test things out for yourself, go to http://www.andurilonline.com/book/calculator.aspx and play with the risk tool there.

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Trade Risk Management

The probability of loss on any given trade is most often assigned to the timing of position entry and exit. That is a function of the trading system or methodology employed, which will be discussed later. Predicting the market return of any given period, even in a binary up/down fashion, is a difficult proposition at best. In other words, whether any given trade ends up a winner or loser is often entirely up to chance.

As a trader, you will do your best to put the odds in your favor, or at least to know what the odds are likely to be (we hope!). Despite that, you will never really know what is going to happen on any given trade, so the control of whether a specific trade is going to be a winner or loser is out of your hands. Even a trading system with a 99% win rate will have a loser somewhere along the way, and it is virtually impossible to accurately predict when that one loss is going to occur.

While you may not be able to do much about whether a specific trades is profitable or not, you can manage the size of the loss, should one occur. This is done in two primary ways – stops and position size.

Stops

Stop orders (stops) are a commonly used type of market entry or exit order. In particular, they are a tool employed by traders with open positions to get out of them at some predetermined point. Someone with an active long position can place a sell stop below the market to cap a loss at a certain point.

For example, a trader who buys 100 shares of XYZ stock at 100 might put a stop at 95. That stop would be triggered if the market moves down to 95, at which point the shares would be sold. The trader would lose $500 on the trade, but would be protected from a larger loss should XYZ continue to move lower.

In the same manner, a short position would be protected by a stop placed above the current market price.

In some cases, traders will adjust the stops as the market moves in the intended direction to lock in profits.


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Let us say, for example, that a trader sells gold at $400 and places a stop at $410, meaning her position would be exited if the market rose to $410 or higher. If gold drops to $350, the trader could move her stop down to something like $370. That would lock in $30 in profits, while keeping the trade open for further gains. These kinds of orders are called trailing stops. As the market moves, the stop is trailed along.

The basic idea here is that with a stop you are trying to prevent a loss greater than some amount, or to prevent a winning trade from losing too much ground. In this way, stops are a staple of most traders’ money management strategy.

It must be stated, however, that stops are in no way guarantees. A stop order becomes a market order when the order price is reached or exceeded. If the market is moving rapidly at the time the stop level is hit, the actual execution price of the trade could vary from the order price.

For example, if you have a sell stop at 9.75, you could see that filled at 9.76, 9.70, 9.50, or any number of other places. Generally, it will be close to you order price in active markets, but you cannot assume a specific price for a fill, even in electronically traded markets, because there must be an order on the other side as well.

This sort of risk is especially apparent where there are discrete openings and closings, like in the stock and futures markets. If prices move between one day’s close and the next day’s open, as could happen if there was a significant news item, the stop can get filled significantly away from the order price. It is unavoidable when it happens, and is something to take in to account when developing a strategy for stop placement.

Trading Limits

Trade2Win Board Quote

I also ensure any total position size will not destroy me given a catastrophy (i.e. assuming the market closes mid session thus destroying the protection of any market stop losses). This normally limits how big I can run a system rather than anything else.

Tuffty

http://www.trade2win.com/boards/showthread.php?t=15424

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Adverse overnight moves are not the only thing that can cause order fills well away from the expected level. In many markets, especially futures, there are price movement limits known as daily trading limits. These are daily barriers based on the previous day’s close beyond which prices may not trade during a given session.

Corn futures, which trade on the Chicago Board of Trade (CBOT), is an example of this. They have a 20 cent per bushel limit, which is equivalent to $1000 per futures contract. That means the price cannot rise or fall more than 20 cents on any given day.

Limits can lead to a situation in which a market goes lock limit. Basically, that means the price at which the market wants to trade at is beyond the allowable one as per the exchange’s limits. When that happens, prices move to the limit, but no actual trading takes place. No trading means no stop order fills, which means you could be stuck in a position going rapidly against you.

Other Restrictions

There are other forms of trading limitations across the markets, sometimes referred to as circuit breakers. They range from restrictions on the types of trades allowed (such as the well known “up-tick” rule in the stock market where one can only sell short at a price higher than the last one transacted) to actual trading halts if certain daily barriers are hit (as instituted in the U.S. stock market following the Crash of 1987).

The reasoning behind daily price limits and circuit breaker type actions is to calm the markets in the face of extreme volatility. The idea is that if traders are given some time to gather themselves and settle, it should lead to less frantic activity.

Even though these restrictions are fine in principle, they actually can increase a trader’s stress level. No one wants to be left wondering if, when, and at what price he/she will be able to exit a position which is under pressure. It is a horrifying situation.

Position Size

Stops are one way traders try to control their potential losses for a given trade. The other way to do that is in the decision of how large or small a position is taken.


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Determining your proper trade position size can sometimes be very easy. There are markets which force you to take on positions of a certain minimum size. That makes position sizing very direct. Alas, that sort of circumstance can lead to trouble, though.

Consider the futures market where there are fixed contract sizes. If you want to trade the e-mini S&P 500 index contract, for example, you have to take on a position with a $50 per point value. Say you want to risk $500 on the trade. That means 10 points, so you place your stop 10 points away from your entry price.

That all sounds good, but what if the normal volatility of the index for the timeframe of your intended trade exceeds 10 points? That means there are pretty good odds your stop gets hit. It is too tight.

This is a mistake a lot of traders make. They decide first how many contracts they want to trade. Then set the stop so they are only risking the amount they want to risk. In this way, they think they are being prudent because they are using stops and not taking too big a loss. Sounds like a solid money management plan.

Why is this a mistake?

Because it leads them to place their stops too close. That, in turn, increases the likelihood of the trade being a loser. Sure, they may not take a big loss. Instead, they will take a series of small ones. It will be a slow death instead of a fast one. Placing stops too tight will turn a good, profitable trading method or system into a losing one. It will produce more losers than it should.

Stops have to be placed outside of what would be the normally expected trading range for the market in question over the holding period expected. They will be closer for short-term trades than for longer-term ones. They will be further away for more volatile markets than for quieter ones. Trades must allow for market fluctuation room because they do not often go in straight lines.

So what is the right way to do it?

Selecting the right position size is done quite simply. You figure out what you are willing to risk on a given trade, for example $1000. Then you figure out what the expected risk for a position is going to be. Maybe it is $500 per unit. You then take the first number and divide it by the second to get your position size. In this case,

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that would be two units ($1000/$500).

Here is the catch for many part-time traders, especially those with only small portfolios. Sometimes the second number is bigger than the first number, meaning the risk on the trade in question is more than they have decided is acceptable. What do you do then?

The answer is easy. You do not enter that trade. You let it go and wait for another that fits your risk profile. Remember, you do not have to trade. That is one of the advantages of being a part-time trader. Your livelihood does not depend on it, so you can pick and choose only the best trading opportunities.

We know that it is hard to let what appears to be a good trade pass you by with getting in. That is part of the discipline of the money management process, though. It is important that you stick to the strategy you put together. It is there for a reason – to ensure you do not take on too much risk and cause major damage to your portfolio. Remember, as good as that trade looks, it could still be a loser. How would you feel after losing more than you should have?

Hedging

There is a third way to control the downside of a specific trade, hedging. Hedging is the process by which you use a second position to offset some of the risk associated with a particular trade. It is not a common part of trading when thinking primarily of speculation, but you can do it. In this regard, the type of hedge you would use is to offset one or more risks which are not specific to the instrument you are trading, but which may have influence on its price activity.

For example, if you expect Intel to report good chip sales you might take a long position in the stock to profit from a move up in

Trade2Win Board Quote

You look at where you need to set your stop (your risk).

You look at how much of your capital you wish to assign to that risk.

You calculate the number of shares/points you can buy/sell. You take the trade (if it meets your entry criteria) and set your stop.

TheBramble

www.trade2win.com/boards/showthread.php?t=18576&page=2&pp=10


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price, and simultaneously short the S&P 500 futures or buy S&P 500 put options. By taking a short position in the index (in some ratio to the Intel position), you would profit from a fall in the overall stock market. This offsets that risk as it relates to your Intel position. The trade is then left with only risks related to Intel itself.

On the flip side, if the market rallies then your short position in the S&P 500 loses money (at a minimum the option premium). In this way, a hedge is like an insurance policy—it protects against a certain kind of exposure, but also has a cost.

The primary reason the vast majority of traders do not hedge is their time-frame. Most traders are fairly short-term in nature. Hedging in that time horizon may not make sense given the relatively small size of the moves in question, and the costs of the additional transactions for entering and exiting the hedge.

For example, interest rates tend to change gradually and their rise or fall takes some additional time to impact the general economy and other markets. A trader who is in and out of positions in days, or perhaps even weeks, is unlikely to feel the impact of such changes. In that case, there is little value in hedging.

That said, for some traders hedging is a useful tool to define and limit position risk. If you are a part-time trader holding long-term positions, there may be a benefit in hedging, as long as the cost is not too high relative to your portfolio.

Hedging can also be done for your portfolio as a whole.

Portfolio Management

Money management can be much more involved than just defining the risk of a specific trade or position. As a part-time trader you will probably be best off if you stick to just a single open position at a time. The more trades you have on, the more time you will have to commit to monitoring and managing them – time you simply may not have. Better to have only one open position which you can fully concentrate on rather than several splitting up your focus.

That said, traders with larger portfolios will sometimes want to spread their risk around and diversify their trading activities. There are also times when a great opportunity comes along that just

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cannot be ignored. That is when the unified money management strategy comes in to play.

The portfolio side of risk and money management is where you must step away from taking a trade-by-trade view of things and shift to a wider focus. Failure to do so leads to an overly narrow outlook in which you fail to understand the way that combined positions can increase or decrease your overall risk.

Correlated Trades

As soon as you have multiple open positions you have to consider the question of their correlation. Do the markets or instruments you hold tend to move in the same direction? Do they tend to move in opposite directions? This is extremely important to the health of your portfolio.

Refer to the charts below. The top is Gold from early 2003 in to early 2005. The lower one is EUR/USD (US dollars per Euro) for the same time frame. As Gold is priced in Dollars, the metal tends to appreciate as the currency declines in value (a rise in EUR/USD means the Dollar is losing value against the Euro). It is easy to see the general correlation when viewing the charts.

2003 2004 2005310320330340350360370380390400410420430440450460Gold (434.000, 434.000, 423.250, 425.350, -9.14999)


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2003 2004 2005

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Another example of correlated movement is equities and fixed income (interest rates). Stocks and bonds (or notes) tend to trade in the same direction since declining interest rates are generally positive for corporate earnings. They mean lower discount rates when calculating discounted cash flows in that kind of valuation analysis. You can see this in the charts below of the S&P 500 index and 10-year Treasury Note prices respectively. While the amplitude of the changes may differ, sometimes dramatically, both instruments trended in the same direction from 1982 to 2006.

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S&P 500 NDX Continuous (1,281.80, 1,289.70, 1,246.80, 1,247.50, -31.9000)

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In the increasingly global financial environment, markets are linked to each other and influenced by similar things. Therefore they will often move in similar ways, resulting in positive correlations (or meaningful negative ones for that matter.).

This is extremely important in assessing your overall portfolio risk. It is very easy to have highly correlated positions without thinking about it until suddenly there is a large loss when both positions go negative at the same time.

Were you to actually calculate the correlation coefficient for Gold and EUR/USD or Stocks and Bonds during the timeframes depicted in the charts on the previous page, the result would not be 1.0. It is almost never going to be 1.0 in any pair of markets or instruments. But it doesn’t need to be to create excess risk.

If you hold a position in two markets or instruments which are even modestly correlated, the overall risk to the portfolio can be significantly increased, theoretically up to double. This is often overlooked because if things go well (both positions profiting simultaneously), the return on your portfolio is higher than it would be otherwise.

The risk of correlated positions is usually only brought home when something happens that makes both positions go negative at the same time. It could be a news report or a data release, or just the normal course of trading activity with no overt cause.


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If such an occurrence takes place in your portfolio, for whatever reason, you will be left staring at a larger than anticipated loss and cursing your foolishness at taking so much risk. You should try to eliminate (or at least severely reduce) the unfortunate experience of looking back with hindsight and realizing that something different should have been done, which could have been prevented by considering correlation.

The markets, however, do not always track each other. Even well correlated ones will diverge from time to time.

Refer to points A and B on the S&P 500 and 10-Year Note charts which follow as an example. While the 10-year dropped sharply between the two points, the S&P barely ticked lower at all. (It is interesting to note that the fall from point A to point B in the 10-year took place in 1999 representing a sharp rise in interest rates - an omen of the collapse in stocks that would come in 2000?

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These sorts of disconnects between the markets happen frequently.

Refer back to the Gold and EUR/USD example.

2 0 0 4 F e b r u a ry A p ri l M a y J u n e J u

3 7 0

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4 1 54 2 0

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G o l d (4 2 9 .6 5 0 , 4 3 0 .9 5 0 , 4 2 3 . 2 5 0 , 4 2 5 .3 5 0 , -4 .2 9 9 9 9 )


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2 0 0 4 F e b M a r A p r M a y J u n J u l

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1 .2 9E u ro ( 1 .2 9 5 8 0 , 1 .2 9 6 5 0 , 1 .2 8 0 8 0 , 1 .2 8 3 5 0 , -0 .0 1 2 10 )

The charts above are taken from the first half of 2004, as a subsection of the earlier charts which showed fairly well correlated movement. Notice that these charts are not nearly as well correlated in the first half of the plot period. During January and February Gold was in a down trend while EUR/USD actually made a new high. Then the two flipped courses. Gold rallied through March while EUR/USD dropped steadily.

It is exactly this kind of action which demonstrates why the trader must always be aware of the current linkages and correlations when putting on positions in multiple markets and/or instruments.

We don’t want to say that having multiple trades active is a bad thing and should always be avoided. In fact it must be said that you can actually lower the risk in your portfolio by combining multiple positions. That normally means having positions with negative or near zero correlations.

The really important thing to take away from this correlation discussion, is that you must think in terms of the future. It is all fine and good if one market has a particular correlation coefficient when compared to another over the last whatever period of time, but it means nothing if the markets do not have the same linkage going forward.

Trading is about expectations and so too is money management. When looking at the correlations between two positions (active or

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proposed), you have to make an assessment (forecast, if you like) as to whether that linkage will change, and if so, how. To do otherwise is like driving a car looking only in the rear view mirror.

That ties in with our next topic.

Spreads

Something that needs to be addressed at this point is the concept of the spread trade. It represents a middle ground between a single trade and a multiple trade position. Often times, however, the spread is confused with hedging.

A hedge is defined by what is trying to be accomplished - specifically, to offset one or more specific risks associated with the position being held. It is, as noted, comparable to taking out an insurance policy.

A spread position, on the other hand, is one in which offsetting trades are made in two or more related, but different instruments. The objective is to profit from the changes in the price or some other differential between the instruments in question. This is not the same as a hedge, even though some tend to equate the two. The spread does not have the insurance policy type characteristics.

An example of a spread would be buying a 2-year note and selling a 10-year note. In this case, you are making a bet that the interest rate spread between the shorter-term and longer-term maturities is going to widen (yield curve will steepen). Another kind of spread trade would be to buy gold and sell platinum in expectation that the price of the former will rise more than the price of the latter (or fall less).

To make a direct hedge/spread comparison, let us start with a long position in General Motors stock. We bought the shares because we think GM is going to see excellent earnings growth in the quarters ahead. We are concerned, however, that the market as a whole might not perform very well in the near future, which could put pressure on the price of the stock. As a result, we buy S&P 500 put options, so that if the market does fall, we are protected. That would be a hedge.

In this case, where we want to guard against a broad stock market decline, we would NOT want to take a short position in another


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auto stock such as Ford. While it might provide us some protection, one stock is hardly likely to provide a good representation of the market as a whole, or even necessarily a market sector. It is an inefficient hedge, as Ford-specific factors could be the dominant reasons for variation in the price of Ford stock. Think about something like a product recall which would certainly pressure Ford’s earnings, but is unlikely to influence the general state of the automotive sector over much.

If, on the other hand, we think that GM is likely to take market share away from Ford, then we can take a short position in the latter in conjunction with our long position in GM. In that scenario we would expect GM stock to outperform Ford stock, regardless of how the overall market performs. This is a spread trade, which is also sometimes referred to as a matched pair trade.

The difference between the two positions is subtle, but important.

In both case we are taking opposing positions in securities we expect to move in basically the same direction, though in the spread case we may expect GM to rise and Ford to fall. In the hedge situation, however, we are trying to limit our downside - at least as caused by one potential risk factor - which can cut down our profit potential.

The spread trade, however, is basically open-ended. It can go in either direction with a virtually limitless amount.

Your Plan

The idea of risk or money management for the trader is inherently a negative one. This can be a very unusual situation for those who are used to thinking in positive terms. Nevertheless, it is important to approach your trading in the proper manner.

It is very easy to get caught up in fantasizing about big profits, but the successful trader spends their time focusing on the odds of losing and how much. Why? Because there will always be opportunities to make trading profits, but only if one remains in the game. The trader who takes on too much risk increases the odds that he or she will be knocked out of the game, which is why we employ money management strategies.

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Earlier in this chapter we talked about determining your own risk profile and defining it. Now is the time to put that into an action plan to guide your trading. This final section of the chapter presents a series of questions that should be addressed.

How much of a loss in account value are you willing to accept before halting your trading?

Decide where your “uncle” point is—the loss at which you shut everything down and stop trading. Hopefully, this never actually occurs, but if it does you should have a contingency. That is part of the planning process.

The ideal viewpoint here is to pick a point, where if you go beyond it, you have to draw the conclusion that there is either a problem with your trading execution or with your trading system. Either way, it is good to stop and assess things, which is what this kind of circuit-breaker does.

The decision as to where to put this point combines elements of your personal comfort and expectations for the performance of your trading system.

What kind of drawdown are you willing to accept?

This speaks to the earlier discussions of personal risk tolerance. It also brings in the “loss to break-even” analysis mentioned at the start of this chapter. In short, it is the degree to which you are willing to accept fluctuations in your portfolio’s value.

Are you the slow and steady type, or do you not mind riding the roller coaster?

Your decision here will influence the types of trading systems in which you are likely to trade as well as the per trade and overall risk you are willing to take.

How much risk, as a percentage of your portfolio, will you take on a per trade basis?

Some of the best traders of all time limit their per trade risk to no more than 1-2% of their total portfolio worth. This may seem like a very small value, but it must be considered in terms of frequency of trade. Someone who is a day or swing trader, or who operates in


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a similarly short timeframe will have more trades over a given time span than will a longer-term trader. That being the case, they have a higher probability of experiencing a significant run of negative performance than would the less frequent trader.

Here is where we put you through some statistical stuff. Don’t get too worried. It’s not that complicated. We touched on this concept earlier in the chapter.

Assume that we have a trading system with a likelihood of losing on any given which can be expressed as p. For a coin toss kind of system p would be 50%, or 0.5.

With p we can then determine the probability of some number of consecutive losing trades taking place. Call that number x. If we want to consider a five trade losing string, x would be equal to 5.

To get the likelihood of x consecutive losing trades, with p as the probability losing on a given trade, we must calculate the value of p to xth power. or px. Thus, if we have a 50% loss percentage and are considering a run of five consecutive trades, the probability of that occurring is .5x.5x.5x.5x.5=0.03125 (assuming the per trade probabilities are independent, meaning the result of one trade has no impact on the chances of the next trade winning or losing). That is a little more than 3%, which sounds pretty small.

This figure is a bit misleading, though. While it is true that it is unlikely to get five consecutive losses given the probabilities, that is only applicable when all you look at is five trades.

As you go beyond five observations, the odds of having a run of 5 consecutive losses increases, to the point of reaching 100% when the number of trades gets large enough. For example, a day trader making 1 trade per day (about 260 each year) would be almost certain of having at least one run of five losing trades in a row.

As noted, you can run scenarios looking at the probability of an x-loss run given a trade total and success rate with the calculator available at: www.anduriloneline.com/book/calculator.aspx

Having this sort of information at-hand is extremely useful when making risk management decisions. It probably is not a good idea to risk 10% of your account per trade when you have a 75% likelihood of seeing at least one run of five or more consecutive

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losing trades. That’s a fast way to blow up your account.

We have not yet begun working through developing a trading system or method, but you can still make some approximations based on the timeframe you are planning on using. We will revisit this topic later in the text.

How much of your account or portfolio will you have at risk in total at any given time?

If you only plan on trading one position at a time, then the answer is the same as the one in the previous question.

If, however, you plan on having multiple trades open, you need to define what kind of net exposure you will take. You can still use the estimations we discussed above as a guide to where your risk level should be, but you will probably have to make an adjustment.

Instead of thinking in terms of trades, as we were previously, you must think in terms of timeframes. The timeframe in question would be based on the combined holding period of the positions in question. For example, a swing trader who has a 1-3 day holding period on any given trade might think in terms of 2-3 day periods. In that manner, he/she could perform the same kind of loss-run assessment as done above, but with a different perspective.

This is where the correlation discussion we had in the last section comes back in to play. Trading highly correlated positions will create a higher portfolio risk than would be implied by just looking at the each portfolio holding individually. Uncorrelated positions (remember we’re talking on a forward looking basis) will generally decrease that overall risk. It is this unified approach which is your most optimal measure for determining where you should make your portfolio risk cut-off.

Risk Management Plan Application

A plan not applied is a worthless plan. While working through your risk and money management strategy, take the decisions you are making and the way you will apply them seriously. Keep things as simple as possible.

The stress of trading, which can be experienced regardless of whether you are winning or losing, can wreak havoc on your risk


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management strategy. In fact, that is the portion of your overall trading plan most likely to go out the window.

Consider two very simple examples.

Joe has just made a very nice gain. Sue, on the other hand, just experienced a significant loss. Both may feel compelled to trade bigger on their next position. Joe is feeling good. The adrenaline is pumping. “Why not trade bigger? The system is doing well. Let me see if I can improve my returns.”

Sue, on the other hand, might think about making that loss back. “It’s a good system, after all. Why not trade a little bigger this time and make up for the loss?” Notice that neither is thinking about deviating from the trading system at this point, just the risk management strategy. They have both stopped thinking about the potential for loss on the next trade.

The important thing to take away from this chapter is that you must either think of risk on the front end of the trade or face the prospect of realizing the riskiness of market participation at some future point. It can be compared to car upkeep and maintenance. You can either do the little things to keep your car in good shape (oil changes, regular service, etc.), or you can wait for a major problem to crop up which will cost far more in time or money than had you just done what you should have done along the way.

At this stage we have sufficiently begun to address the requirements for risk and money management in our trading. Do not think we are done with the topic, though. It will come back in to play later.

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Risk management Strategies For Part Time Trading

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