Risk management is the backbone of every good trading system
Rigorous risk management allows you to expect to last long enough in the market to gain an advantage, apply it consistently, and earn accordingly.
There is a big difference between having a real risk management and to believe having one. These are of course two different things.
“There is a big difference between having a real risk management system and to believe having one.”
First let's define what good risk management is.
To me, good risk management consists in preserving your capital (1) and managing adverse movement in open positions (2).
The first requirement is to implement a systematic protection of your capital committed on each trade through the use of what is called a "stop" or "stop loss".
When you are long the stock, it is a price level at which or below you shares are sold entirely at market price.
This price can be lower than your original stop depending on the stock liquidity and the bid-ask spread.
Let's take an example to see more clearly how it works.
You buy a stock at $10 and decide to put a stop at $9.
Once you have placed your trade, the stock price will fluctuate, as you might imagine, either up or down.
If the price of the security touches $9, the stop order will be triggered and will be treated like a market order.
And that price won't always be $9 ...
Why? Because a market order involves looking for a counterparty at any price as long as it is executed on all shares.
And depending on the liquidity of the stock, you may suffer from what is called slippage cost which will be the difference between the desired exit price and the actual price of execution.
On a more practical level, a number of years ago it was necessary with some brokers to place your order and then place a stop once your order was executed. This system was very pernicious because once you are in the market you are suddenly exposed to the 3-headed hydra "fear, hope and greed".
If as soon as you buy your stock the stock starts to go up, you will feel like you are a genius and that the market must ultimately reward you for who you are and then you will be reluctant to place your stop.
Why would I protect my capital when my stock is going in the expected direction?
Greed, over-confidence and pride are at stake ...
Then, your stock starts falling and incredulous, you no longer consider for a single second to put the stop you initially decided to enter, refusing to suffer a loss as the stock keeps falling.
The loss isn’t just monetary. Loss is what you refuse, viscerally to accept. It challenges us entirely.
We have always been told that we had to win, first at school because we had to bring back good grades. Getting a good grade is ultimately winning, but more than that is not losing.
Not having to justify ourselves to our parents, the eyes of your classmates or teachers or in the worst case, humiliation. Not to be at the bottom of the ladder when others are climbing...
Not to lose is not to be fired, not to be dumped by your girlfriend and of course not to lose a loved one.
In short, a trading loss very often goes hand in hand with hope. Hope that decimates countless traders with metronome regularity every single day.
And if hope has not come along, fear and greed will undoubtedly do the rest sooner or later ...
Today, you have the option of placing your buy order (or sell short if you are speculating on the downside) and at the same time a « stop loss ».
It’s a bit like jumping into the water every day with your life jacket on without exception even in a sea of oil.
But that is not enough. Why?
Because once in the water, you shouldn't take off your life jacket ... ever.
What seems so natural in life becomes much less so in trading.
Remember, trading for a living is the same as starting a business which involves a bit of administrative work including accounting, which you could obviously delegate to a specialist in a "classic" business.
In the markets you are on your own, both the boss and the sole multi-task employee of your own business.
For those who are not too familiar with accounting, there is what is called the sacrosanct principle of prudence that must be followed.
For example, products (turnover is one of them) should be recorded only if they are certain. The issuance of an invoice is the operative event for its registration.
On the other hand, charges must be recorded even if they are probable.
For example, if you think that some customers will not pay you, you should depreciate that account.
In trading, you can place a stop but never consider it to be executed. At no time is it imaginable that we could lose.
This technical configuration is too good, the fundamentals of this company are exceptional....
In short, everything is for the best in the best of all possible worlds. And everything is going so well on this time you have twice the position size.
With this maverick attitude you take the plunge. And everything starts getting complicated ...
The market is starting to shift and so is your stock. You bought at $10 and your stop is at $9.
You stock start nosediving and dropping to $9.10. There you tell yourself that it would be so stupid to get stopped out since your stock price is so closed from you stop.
Than you decide to shift your stop to $8.49. The price continues to fall and after minor fluctuations just above your stop level, it breaks down under $9 and reaches $8.95.
Then it goes back to $9.20 which confirms your decision to have moved down your stop. You were right.
In short, one thing leading to another, you shift your stop once again to $7.99 and you lose twice as much as you should have with twice your maximum position size because this time was different.
Your loss is therefore 4 times higher than expected.
And by a domino effect for one real reason: you cannot accept to lose. You have not provisioned your loss BEFORE entering the market.
The first loss is always the best. To refuse to take a small loss is to expose yourself to the mother of all losses ...
“Even before placing a trade, you must have recorded in your mind the maximum acceptable loss.”
Remember that there is an arithmetic progression of the losses but a geometric progression of the gains necessary to recoup those losses. If you lose 50% of your capital, you will need 100% gain to return to your initial level.
Never risk more than 1 to 1.5% of your capital for a single trade. Never.
For example, with a 1% risk per trade you will lose 63,40% of you capital with 100 consecutive losses.
At 10%, with 10 consecutive losses you will lose of 65,13% of your trading account. And believe me it happens.
Regarding the overall exposure of your portfolio, I recommend against exposing your capital to a potential loss of more than 5/6 %.
To do this, as soon as your stock has progressed sufficiently, ask yourself at what point it seems unacceptable to envisage a loss and move up your stop at you average entry price (if you are long).
If your stock rises 5% above you entry price, you could put you stop at cost. It can be 10% or 20%. It depends but don’t let a winner turn into a loser...
Protecting your capital should be THE top priority before considering winning.
The second component of good risk management is relating to managing volatility and adverse movements on your open positions.
If you are on a winning trade, your position size on this specific trade will inflate accordingly to the price movement in your favor and proportionally to your position size in you capital . At some point you can suffer a huge drawdown if this stock goes against you.
You do not want to suffer too much drawdown even if it is considered as « bank money » for 2 reasons:
-First you could be prone to psychological traps. Too large movements in your trading account could trigger a loss aversion bias because you would not « assume» such a volatility. Or over confidence bias because you were able to capture such a big run on a single trade
-Second having a performance of 20% in a given year with a drawdown of 25% is like having bet $1 to get less than $1. This is what the sharpe ratio tells you. Ceteris paribus, the higher your sharpe, the better
How to deal with that?
There are different ways to deal with that and it depend on several factors but you should have a small position size especially if you have a high-risk reward ratio.
1-You could consider to take part of you gains when your stock is up that is selling into force
2-You could have an initial position size that take into account large movement in you favor so that a trade does not account too high a proportion of your whole portfolio. Consider making deep and appropriate backtesting.
3-You could reduce your initial position size while in a drawdown at a geometric pace that is cutting your position size by 20% when your drawdown is 10% for example.
Why? Because the pace at which you can recoup your losses follow a geometric progression.
If you lose 10% of your capital you need to gain 11,1% to recoup this loss...
If you lose 20% of your capital you need to gain 25% to recoup this loss...
If you lose 50% of your capital you need to gain 100% to recoup this loss...
And so on….
“We are programmed to avoid losing and we are able to do everything for that. Even if it means losing much more…”
Why does risk management seem so easy to understand intellectually and yet so hard to implement on a practical level?
Because we are human beings and losing is something we want to avoid at all price.
Then and paradoxically, the fear of losing makes us natural losers.
Not just for the sake of money (although the fear of losing money is one of the biggest human fears) but for a physiological reason that comes down to survival instinct.
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