Risk Management

Risk management, or position sizing, is paramount to the longevity of your career as a trader. The bottom line really comes down to this. The more you bet on a single trade, the more volatile your returns will become. The more volatile your account balance is the greater the emotional roller coaster you will ride. Dramatic ups and down are not appropriate for a career trader. It will create an unsettling environment both in your professional life as well as at home and it may also adversely impact on your health. Therefore it’s important to manage your exposure to risk and in turn create some trading and health longevity for yourself.

One of the simplest ways of managing risk is to simply divide your trading capital into equal parts. This may not be the best way, but it’s certainly better than no way. I’ll get onto what I think is the best way shortly, but for now let’s just use this simple analogy.

Analogy

Assume you are a professional golfer and compete on the pro tour. The tour events are made up of fours days of golf and each of those days you play 18 holes. In total you will play 72 holes. Now, as much as you’d like to play every hole perfectly, you know it’s impossible. Therefore you simply attempt to play as best you can. But really the goal in the back of your mind is not to have an extremely bad hole that may destroy the whole round, or the whole tournament.

In essence you are managing your score by not doing anything completely stupid. Like hitting bold shots or taking on too many risky shots. You realise that if you fail to keep the ball on the fairway then you will be penalised harshly for the oversight. When playing the tournaments you are aware of external factors that may influence the shot you play. Factors such as the wind, rain or dryness, angle of the fairways and even the competition can have an adverse impact on your game. Commentators may influence your line of thinking.

When faced with all these factors a good golfer will simply take one shot at a time, micro managing his game by not thinking about the end result. He simply plays the shot that’s in front of him, plays for safety, he plays to stay in the game for the long haul. Will play each shot so he can be in contention at the end of the tournament. Knows he can never win if he’s not even in contention.

Apply this Analogy to Trading

If we apply this analogy to trading then hitting a bad shot into a water hazard and being penalised is like taking a much larger loss than average. We know that every trade will not be a winner, just like a pro golfer will know that not every shot will be perfect. But we trade to stay in play; we only use a small amount of risk on each trade. If we do have some bad trades, which are bound to occur, they will not disrupt the end game, which is to have enough capital to keep on trading.

A single hole cannot be responsible for winning the tournament, but a very bad hole can certainly make it impossible to win. A good trader will understand that some trades will be losers, some trades will be winners and some trades will be great wins, but he does his best to ensure that a single trade or a string of losing trades will not destroy his account balance.

You might think that if you win about 50% of the time then a winning trade would surely follow each losing trade. In fact nothing could be further from the truth. I remember waiting for a plane in Hong Kong several years ago and being bored. I started tossing a coin and counting how often a streak of heads or tails would occur, after all a coin only has two sides and in effect has a 50/50 chance of coming up heads or tails. Now mathematically I know the outcome, but I wanted to see it for myself. Sure enough I was able to toss a streak of 9 heads or tails on quite a few occasions. Streaks of 5 were extremely common.

Mathematically Ascertain an Idea

If we were able to mathematically ascertain an idea of what was probable for a losing streak we can better prepare ourselves for its possible impact – financially and emotionally – when it does occur. I’ve tested this for you:

Using 10,000 trades with an average win rate of 50%, there is a chance that we might 16 consecutive losers in a row. It’s always best to err further on the side of caution and expect that perhaps worse may occur. You can test it on a site such as https://www.random.org/coins/

After about 5 consecutive losses most amateur traders either give up or try a different trading strategy. If you know to expect consecutive losses then you will be more likely to handle those losses.

Also consider the emotional consequences when your capital starts being depleted by a strong of losing trades. What will your spouse say? Will you tell your friends? How will your mood be at work the next day? Will you have a few extra drinks at the pub that night? So if you prepare yourself. Then when the inevitable losing streak comes along, you’ll be ready and know that it’s just part of trading.