THE NEW TRADING OF A LIVING- RISK MANAGEMENT

THE NEW TRADING OF A LIVING



RISK MANAGEMENT

A good trading system delivers greater profits than losses over a period of time, but even the most carefully designed system doesn’t guarantee success in every trade. No system can assure you of never having a losing trade or even a series of losing trades.

A system is a plan, but as Helmuth von Moltke, a nineteenth-century German field marshal, wrote: “No plan survives contact with the enemy.” The U.S. boxer Mike Tyson, quoted by The Economist, put it more bluntly: “Everyone has a plan ’til they get punched in the mouth.” This is why risk control must be an essential part of every trading system. The inability to manage losses is one of the worst pitfalls in trading. 

Beginners freeze like deer in the headlights when a deepening loss starts wiping out profits of many good trades. It’s a general human tendency to take profits quickly but wait for losing trades to come back to even. By the time the despairing amateur gives up hope and closes his trade with a terrible loss, his account is badly and sometimes irreparably damaged. To be a successful trader, you need to learn risk management rules and firmly implement them.

Emotions and Probabilities

Money stirs up powerful feelings. The emotional storms, raised by making or losing money, hit our trading. A beginner rushing to place an order may feel giddy with the excitement. He will soon find out that the market offers a painfully expensive form of entertainment. Early in my career, I heard from a professional trader that “successful trading should be a little bit boring.” He spent long hours each day doing homework, sifting through market data, calculating risks, and maintaining records.

Those time-consuming tasks weren’t exciting—but his success was built on such grunt work. Beginners and gamblers get a full load of entertainment, but pay for it with losses. Another emotional mistake is counting money in open trades. Newbies dream about what they can buy with open profits or freeze from the shock of comparing open losses to their paychecks. Thinking about money interferes with decision making. Professionals focus on managing trades; they count money only after those trades are closed.

A trader who counts profits in an open trade is like a lawyer who, in the middle of a trial, starts dreaming of what he’ll buy with his fee. That trial is still going on, his opponents are building a case against his client, and counting money will not help him win—quite the contrary, it’ll distract him and cause him to lose. An amateur who becomes upset counting losses in an open trade is like a surgeon who throws a tray of instruments after the patient on the table starts bleeding—his frustration will not improve the outcome of the case.

Professional traders don’t count money in open trades. They do it at the end of an accounting period, such as a month. If you were to ask me about an open trade, I could answer that it’s a bit ahead, a lot ahead, or a bit behind. If you were to press me for a number, I might tell you how many ticks I’m ahead or behind, but I’ll never translate those ticks into dollars. It took me years to train myself to break the destructive habit of counting money in open trades. I can count ticks, but my mind stops before converting them into dollars. 

It’s like being on a diet—there is plenty of food around, but you don’t touch it. Focus on managing your trade, and the money will follow almost as an afterthought. Another key point: a professional doesn’t get worked up about his wins or losses in a single trade. There is a great deal of randomness in the markets. We can do everything right—and still end up with a losing trade, just like a surgeon can do everything right and still lose a patient.

That’s why a trader should care only about having a method with a positive expectation and work on being profitable at the end of his accounting period. The goal of a successful professional in any field is to reach his personal best—to become the best doctor, the best lawyer, or the best trader. Handle each trade like a surgical procedure—seriously, soberly, without sloppiness or shortcuts. Concentrate on trading right. When you work this way, money will come later.

Why Johnny Can’t Sell

Your survival and success depend on your willingness to cut losses while they’re relatively small. When a trade starts going against a beginner, he hangs on, hoping for a reversal in his favor. When he gets a margin call, he scrambles to send more money to the broker, as if the initial loss hadn’t been bad enough. Why should a losing trade turn in his favor? There’s no logical reason, only wishful thinking.

Stubbornly holding a losing trade only deepens the wound. Losses have a way of snowballing until what initially seemed like a bad loss starts looking like a bargain because the current drawdown is so much worse. Finally, a desperate loser bites the bullet and closes out a trade, taking a severe loss. Right after he exits, the market reverses and comes roaring back.

The trader is ready to smash his head against a wall—had he hung on, he would have made money. Such reversals happen time and again because most losers respond to the same stimuli. People have similar emotions, regardless of their nationality or education. A frightened trader with sweaty palms and a pounding heart feels and acts the same way, whether he grew up in New York or Hong Kong and whether he had 2 or 20 years of schooling.

The intellectual demands of trading are modest, but its emotional demands are immense. Many years ago, a highly educated but very emotional trader showed me how to trade divergences near channel walls. I fine-tuned his method, added risk management rules, and continue to make money with it to this day. The man who taught me had busted out because of his lack of discipline and ended up going door to door, selling aluminum siding. Emotional trading and impulsivity are not good for success.

Roy Shapiro, a New York psychologist from whose article the title of this subchapter is borrowed, writes: “With great hope, in the private place where we make our trading decisions, our current idea is made ready.... one difficulty in selling is the attachment experienced toward the position. After all, once something is ours, we naturally tend to become attached to it.... This attachment to the things we buy has been called the “endowment effect” by psychologists and economists and we all recognize it in our financial transactions as well as in our inability to part with that old sports jacket hanging in the closet. 

The speculator is the parent of the idea.... the position takes on meaning as a personal extension of self, almost as one’s child might.... Another reason that Johnny does not sell, even when the position may be losing ground, is because he wants to dream.... For many, at the moment of purchase, critical judgment weakens and hope ascends to govern the decision process.” Dreaming in the markets is a luxury we can’t afford.

Dr. Shapiro describes a test that shows how people conduct business involving a chance. First, a group of people are given a choice: a 75 percent chance to win $1000 with a 25 percent chance of getting nothing—or a sure $700. Four out of five subjects take the second choice, even after it is explained to them that the first choice leads to a $750 gain over time. The majority makes the emotional decision and settles for a smaller gain.

Another test is given: People have to choose between a sure loss of $700 or a 75 percent chance of losing $1000 and a 25 percent chance of losing nothing. Three out of four take the second choice, condemning themselves to lose $50 more than they have to. In trying to avoid risk, they maximize losses!

Emotional traders crave certain gains and turn down profitable wagers that involve uncertainty. They go into risky gambles to postpone taking losses. It is human nature to take profits quickly and losses slowly. The irrational behavior increases when people feel under pressure. According to Dr. Shapiro, at the racetrack, “bets on long shots increase in the last two races of the day.”

Prof. Daniel Kahneman writes in his book Thinking, Fast and Slow: “The sure loss is very aversive, and this drives you to take the risk ... Considerable loss aversion exists even when the amount at risk is minuscule relative to your wealth ... losses loom larger than corresponding gains.” He adds: “Animals, including people, fight harder to prevent losses than to achieve gains” and spells it out: “People who face very bad options take desperate gambles, accepting a high probability of making things worse in exchange for a small hope of avoiding a large loss. 

Risk taking of this kind often turns manageable failures into disasters.” Why do we act this way? Prof. Kahneman explains: “Except for the very poor, for whom income coincides with survival, the main motivators of money-seeking are not necessarily economic. Money is a proxy for points on a scale of self-regard and achievement.” These rewards and punishments, promises and threats, are all in our heads.

Emotional trading destroys losers. A review of trading records usually shows that the worst damage was done by a few large losses or a long string of losses, while trying to trade one’s way out of a hole. The discipline of good money management would have kept us out of that hole in the first place.

Probability and Innumeracy

Innumeracy—the inability to count or understand the basic notions of probability— is a fatal weakness for traders. The counting skills aren’t hard, can be picked up from many basic books, and then sharpened with some practice. The lively book Innumeracy by John Allen Paulos is an excellent primer on the concepts of probability. 

Paulos describes being told by a seemingly intelligent person at a cocktail party: “If the chance of rain is 50 percent on Saturday and 50 percent on Sunday, then it is 100 percent certain it will be a rainy weekend.” Someone who understands so little about probability is sure to lose money trading. 

You owe it to yourself to develop a grasp of the basic mathematical and logical concepts involved in trading. There are very few ironclad certainties in market analysis, which is largely based on probabilities. “If the signals A and B are present, then the outcome C will occur” is not the kind of logic that holds up in the markets.

Ralph Vince begins his important book Portfolio Management Formulas with this delightful paragraph: “Toss a coin in the air. For an instant you experience one of the most fascinating paradoxes of nature—the random process. While the coin is in the air there is no way to tell for certain whether it will land heads or tails. Yet over many tosses, the outcome can be reasonably predicted.”

Mathematical expectation is an important concept for traders. Each trade has either a positive expectation, also called the player’s edge, or a negative expectation, also called the house advantage, depending on who has better odds in a game. If you and I flip a coin, neither of us has an edge—each has a 50 percent chance of winning. If you play the same game in a casino that takes five percent from every pot, you’ll win only 95 cents for every dollar you lose. This “house advantage” will create a negative mathematical expectation. No system for money management can beat a negative expectation over a period of time.

A Positive Expectation

A skilled card-counter has an edge against a casino, unless they detect him and throw him out. Casinos love drunken gamblers but hate card counters. An edge lets you win more often than lose over a period of time. Without an edge, you might as well give money to charity. In trading, the edge comes from systems that deliver greater profits than losses, after slippage and commissions, over a period of time. Acting on hunches leads to losses.

The best trading systems are simple and robust. They have very few elements. The more complex the systems, the higher the risk that some of its components will break. Traders love to optimize systems, making them fit past data. The trouble is, your broker won’t let you trade in the past. Markets change, and indicator parameters that would have nailed the trends last month are unlikely to nail them a month from now.

Instead of optimizing your system, try to de-optimize it. A robust system holds up well to market changes and beats a heavily optimized system in real trading. Finally, once you develop a good system, stop messing with it. If you like to tinker, design another system. As Robert Prechter put it: “Most traders take a good system and destroy it by trying to make it into a perfect system.”

Once you have a trading system that works, it’s time to set the rules for money management. You can win only if you have a positive mathematical expectation from a sensible trading system. Money management will help you exploit a good system, but cannot rescue a bad one.

Businessman’s Risk or Loss

We analyze markets in order to identify trends. Be careful not to become overconfident when anticipating future prices. The future is fundamentally unknowable. When we buy, expecting a rally, it is entirely possible that an unforeseen event may flip the market and send it down. Your actions in response to surprises will define you as a trader. A pro manages his trades, accepting what’s called a “businessman’s risk.” This means that the amount he risks exposes him to only a minor equity drop.

A loss, on the other hand, may threaten an account’s health and even survival. We must draw a clear line between a businessman’s risk and a loss. That border is defined by the fraction of the account a trader puts at risk in a trade. If you follow the risk management rules described below, you’ll accept only a normal businessman’s risk. Violating a well-defined red line will expose you to dangerous losses. “This time is different,” says an undisciplined trader. “I’ll give this trade a little extra room.” The market seduces traders into breaking their rules. Will you follow yours?

Once, I chaired a panel at a gathering of money managers at which one of the presenters had nearly a billion dollars in his fund. A middle-aged man, he got into this business in his 20s, while working for a naval consulting firm after graduate school. Bored with his day job, he designed a trading system but couldn’t trade it because it required a minimum of $200,000, which he didn’t have in those days. “I had to go to other people,” he said, “and ask them for money. Once I explained to them what I was going to do and they gave me money, I had to stick to my system. It would have been unconscionable to deviate from the system I told them I would follow. My poverty worked for me.” Poverty and integrity.

The Two Main Rules of Risk Control

If trading is a high-wire act, then safety demands stringing a net underneath that wire. If we slip, the net will save us from getting smashed against the floor. The only thing better than a safety net is two safety nets: if one doesn’t catch us as we fall, the other will.

Even the best planned trades can go awry because of randomness in the markets. Even the best analyses and the clearest trade setups can’t prevent accidents. What you can control is risk. You do it by managing the size of your trades and the placement of stops. This is how you keep the inevitable losses small, not allowing them to cripple your account, so that you can win in the long run.

Ugly losses stick out like sore thumbs from most account records. Every performance review shows that a single terrible loss or a short string of bad losses did most of the damage to an account. Had a trader cut his losses sooner, his bottom line would have been much higher. Traders dream of profits but freeze when a losing trade hits them. If you follow risk management rules, you’ll quickly get out of harm’s way instead of waiting and praying for the market to turn.

Markets can snuff out an account with a single horrible loss that effectively takes a person out of the game, like a shark bite. Markets can also kill with a series of bites, none of them lethal but combined they strip an account to the bone, like a pack of piranhas. The two pillars of money management are the 2% and 6% Rules. The 2% Rule will save your account from shark bites and the 6% Rule from piranhas.

The Two Worst Mistakes

There are two quick ways to ruin an account: not use stops and put on trades that are too large for that account’s size. Trading without stops exposes you to unlimited losses. We’ll discuss the principles and rules of risk control, but they will work only if you use stops. We want to place our stops neither too far nor too close. At this point, just keep in mind that you must use stops. You have to know your maximum level of risk—it’s as simple as that. If you don’t know your maximum level of risk, you’re flying blind.

The other fatal error is overtrading—putting on trades whose size is too large for your account. This is like putting a huge sail on a small boat—a strong gust of wind will flip the boat over instead of making it go faster. People put on trades that are too large for their accounts out of ignorance, greed, or a combination of both. There is a simple mathematical rule that gives you the maximum size for every trade, as you are about to see.

The Two Percent Rule

One disastrous loss can do to an account what a shark does to a hapless swimmer. A poor beginner who loses a quarter of his equity in a single trade is like a swimmer who just lost an arm or a leg to a shark and is bleeding into the water. He’d have to generate a 33% return on the remaining capital simply to come back to even. The chances of him being able to do that are slim to none.

The typical victim of a “shark bite” loses more money. He loses confidence and becomes fearful of pulling the trigger. The way to avoid “shark bite” losses is by following the 2% Rule. It will limit your losses to a manageable size—to a normal businessman’s risk. The 2% Rule prohibits you from risking more than 2% of your account equity on any single trade. For example, if you have $50,000 in your account, the 2% Rule limits your maximum risk on any trade to $1,000. This is not the size of your trade—it’s the amount you put at risk, based on the distance from your entry to your stop.

Let’s say you decide to buy a stock for $40 and put a stop at $38, just below support. This means you’ll be risking $2 per share. Dividing your total permitted risk of $1,000 by your $2 risk per share tells you that you may trade no more than 500 shares. You are perfectly welcome to trade fewer shares—you don’t have to go the max every time. If you feel very bullish about that stock and want to trade the maximum permitted size, that number of shares will be limited to 500.

Good market analysis alone will not make you a winner. The ability to find good trades will not guarantee success. Markets are full of good analysts who destroy their accounts. You can profit from your research only if you protect yourself from sharks. I’ve seen traders make 20, 30, and once even 50 profitable trades in a row, and still end up losing money. When you’re on a winning streak, it’s easy to feel you’ve figured out the game. Then a disastrous loss wipes out all profits and tears into your equity. You need the shark repellent of good money management.

A good trading system will give you an edge in the long run, but in the short run there is a great deal of randomness in the markets. The outcome of any single trade is close to a toss-up. A professional trader expects to be profitable by the end of the month or the quarter, but ask him whether he’ll make money on his next trade and he’ll honestly say he doesn’t know. That’s why he uses stops: to prevent negative trades from damaging his account. Technical analysis can help you decide where to place a stop, which will limit your loss per share. 

Money management rules will help you protect your account as a whole. The single most important rule is to limit your exposure on any trade to no more than 2% of your account. This rule applies only to money in your trading account. It doesn’t include your savings, equity in your house, retirement account, or Christmas club. Your trading capital is the money you’ve dedicated to trading. This is your true risk capital—the equity in your trading enterprise. If you have separate trading accounts for stocks, futures, and options, apply the 2% Rule to each account separately.

I’ve noticed a curious difference in how people react when they first hear about the 2% Rule. Newbies with small accounts often object that this number is too low. Someone asked me whether the 2% Rule could be increased when he was feeling especially confident about a trade, and I answered that it would be like adding extra length to the cord for bungee jumping because you like the view from the bridge.

Professionals, on the other hand, often say that 2% is too high and they try to risk less. You wouldn’t want to lose 2% of a million dollars on a single trade in one day. A hedge fund manager who consulted with me said that his project for the next six months was to increase his trading size. He never risked more than 0.5% of equity on a trade—and was going to teach himself to risk 1%. Good traders tend to stay well below the 2% limit. Whenever amateurs and professionals are on the opposite sides of an argument, you know which side to choose. Try to risk less than 2%—it is simply the maximum level.

Measure your account equity on the first day of each month. If you start the month with $100,000 in your account, the 2% Rule allows you to risk a maximum of $2,000 per trade. If you have a good month and your equity rises to $105,000, then your 2% limit for the next month will be—what? Quick! Remember, good traders can count! If you have $105,000 in your account, the 2% Rule allows you to risk $2,100 and trade a slightly bigger size. If, on the other hand, you had a bad month and your equity fell to $95,000, the 2% Rule will set your maximum permitted risk at $1,900 per trade for the following month. The 2% Rule links the size of your trades to your performance as well as account size.

The Iron Triangle of Risk Control

How many shares will you buy or sell short in your next trade? Beginners often choose an arbitrary number, such as a thousand or 200 shares. They may buy more if they’ve made money in their latest trade or less if they’ve lost money. In fact, trade size should be based on a formula instead of vague gut feel. Use the 2% Rule to make rational decisions on the maximum number of shares you may buy or sell short in any trade. I named this process “The Iron Triangle of risk control”.

For example, when I volunteered to teach a yearlong course “Money and Trading” in a local high school and wanted to make the experience real for the kids, I opened a $40,000 account. I told my students that if, at the end of the school year, we made money, I’d give half the profit to their school and distribute the rest among class participants. I also told them that their maximum risk per trade was one percent. A kid would stand up in class and make a case for buying Nokia at $16, with a stop at $14.50. “How many shares may we trade?”—I’d ask. With the maximum risk of $400 per trade and $1.50 risk per share, the kids would be allowed to buy 250 shares, with some leeway for commissions.


FIGURE  The Iron Triangle of risk control.

If you have a tiny account, you may end up trading the maximum permitted number of shares each time. As your account grows bigger, you may want to vary the size of your trades: say a third of the maximum for regular trades, two thirds for extra strong trades, and the full amount for exceptional trades. Whatever you do, the Iron Triangle of risk control will set the maximum number of shares you may trade.

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