### THE NEW TRADING OF A LIVING- RISK MANAGEMENT

THE NEW TRADING OF A LIVING

RISK MANAGEMENT

The 2% Rule in the Futures Markets

A trader recently asked me how he could apply the Iron Triangle of risk control to trading e-mini futures in his \$50,000 account. I replied:

A. If you are trading a \$50k account, the 2% Rule would limit your risk on any trade to \$1,000. Let’s say you want to be conservative and risk only 1% of that account, or \$500. That will be the first side of “the Iron Triangle of risk Control.”

B. Suppose you look at your favorite e-minis and want to sell a contract short at 1810, with a profit target at 1790 and a stop at 1816. You’ll be risking 6 points, and since one point in e-minis is worth \$50, your total risk will be \$300. That will be the second side of your Iron Triangle of risk control.

C. Close the triangle by dividing “a” by “b” to find the maximum size you may trade. If your maximum risk is \$500, then one contract, but if \$1,000, then three.

Please meet two futures traders, Mr. Hare and Mr. Turtle, each with a \$50,000 account. The agile Mr. Hare sees that the average daily range in gold is about \$30, worth \$3,000 per day for a single contract. The daily range in corn is about 10 cents, worth \$500 per day for a single contract. He thinks that if he can catch just half of a day’s range, he’ll make \$1,500 per contract in gold, while the same level of skill will bring him only \$250 in corn. Mr. Hare logs into his brokerage account and buys two contracts of gold.

The cautious Mr. Turtle has a different arithmetic. He begins by using the 2% Rule to cap his maximum risk per trade at \$1,000. He sees that it would be impossible to place a meaningful stop while trading gold which can move \$3,000 a day. To buy gold in his account would be like grabbing a very large tiger by a very short tail. If, on the other hand, he trades corn, he’ll have good staying power. That tiger is smaller and has a longer tail, which he can wrap around his wrist. Mr. Turtle buys a contract of corn. Who do you think is more likely to win in the long run, Mr. Hare or Mr. Turtle?

Futures markets are more deadly than stocks not because of any special complexity. Sure, they have some specific angles, but those aren’t too hard to learn. Futures kill traders by seducing them with paper-thin margins. They offer enormous leverage –ability to trade large positions on a 5% margin. This works wonders when the market moves in your favor, but it slices your wallet when the market turns against you. You can succeed in futures only with sensible risk control, using the 2% Rule.

A. Calculate 2% of your account value—this will be the maximum acceptable risk level for any trade. If you have \$50,000 in your futures account, the most you can risk is \$1,000.

B. Examine the charts of the market that interests you and write down your planned entry, target, and stop. Remember: a trade without these three numbers is not a trade but a gamble. Express the value of the move from your entry to your stop in dollars.

C. Divide A by B, and if the result turns out to be less than one, no trade is permitted—it means you cannot afford to trade even one contract.

Let’s review two market examples, featuring similar chart patterns. Let’s assume you have a \$50,000 account, which permits you to risk the maximum of \$1,000 per trade. You can trade futures reasonably safely only with strict money management. The leverage of futures can work for you—as long as you stay away from those contracts that can kill your account.

A professional futures trader surprised me early in my career when he told me he spent a third of his time on risk management. Beginners jump into trades without giving them much thought. Intermediate-level traders focus on market analysis. Professionals dedicate a massive proportion of their time to risk control—and take money away from beginners and amateurs.

FIGURE  Daily charts with 13- and 26-day EMAs and Autoenvelopes. The Impulse system and MACD-Histogram 12-26-9.

If you cannot afford to trade a certain market, you can still download its data, do your homework, and paper trade it as if you were doing it with real money. This will prepare you for the day when your account grows big enough or the market grows quiet enough for you to put on a trade.

The Six Percent Rule

A piranha is a tropical river fish not much bigger than a man’s hand, but with a mean set of teeth. What makes it so dangerous is that it attacks in packs. If a dog, a donkey, or a person stumbles into a tropical stream, a pack of piranhas can attack with such a mass of bites that the victim collapses. A bull can walk into a river, be attacked by a pack of piranhas, and a few minutes later only its bones will be left in the water. A trader, who keeps sharks at bay with the 2% Rule, still needs protection from piranhas. The 6% Rule will save you from being nibbled to death.

Most of us, when we find ourselves in trouble, start pushing harder. Losing traders often take on bigger positions, trying to trade their way out of a hole. A better response to a losing streak is to step aside and take time off to think. The 6% Rule sets a limit on the maximum monthly drawdown in any account. If you reach it, you stop trading for the rest of the month. The 6% Rule forces you to get out of the water before piranhas get you.

The 6% Rule prohibits you from opening any new trades for the rest of the month when the sum of your losses for the current month and the risks in open trades reach 6% of your account equity. We all go through periods when we are in tune with the markets, taking one profit after another. When everything we touch turns to gold, that’s the time to trade actively. There are other times when everything we touch turns into a completely different substance.

We go through periods when our systems go out of sync with the market, delivering one loss after another. It’s important to recognize such dark periods and not push yourself but rather step back. A professional on a losing streak is likely to take a break, continue to monitor the market, and wait to get in gear with it again. Amateurs are more likely to keep pushing until their accounts become crippled. The 6% Rule will make you pause while your account is still largely intact.

The Concept of Available Risk

Before you put on a trade, ask yourself: what would happen if all your trades suddenly turned against you? If you used the 2% Rule to set stops and trade sizes, the 6% Rule will limit the maximum total loss that your account may suffer.

2. Add up your risks on all currently open trades. The dollar risk of any open position is the distance from your entry to the current stop, multiplied by the trade size. Suppose you’ve bought 200 shares for \$50, with a stop at \$48.50, risking \$1.50 per share. In that case, your open risk is \$300. If that trade starts going your way and you move your stop to breakeven, your open risk will become zero.

3. Add the two lines above (losses for the month plus risks on open trades). If their sum comes to 6% of what your account equity was at the beginning of the month, you may not put on another trade until the end of the month or until the open trades move in your favor, allowing you to raise your stops.

The 6% Rule changes the usual question—“do I have enough money for this trade?”—to a much more relevant one—“do I have enough risk available for this trade?” That limit—risking no more than 6% of your account equity in any given month—keeps your total risk under control, ensuring long-term survival. Your total available risk for the month is 6% of your account equity, and the first question to ask yourself when considering a new trade is “Considering all my open and closed trades for this month, do I have enough available risk for this trade?”

If you are near the 6% limit but see a very attractive trade you wouldn’t want to miss, you have two options. You can take profits on one of your open trades to free up available risk. Alternatively, you may tighten some of your protective stops, reducing your open risk. Just be sure that in your eagerness to trade you do not make your stops too tight. Let’s review an example, assuming, for the sake of simplicity, that a trader will risk 2% of his account equity on any given trade.

1. At the end of the month, a trader has \$50,000 in his account, with no open positions. He writes down his maximum risk levels for the month ahead—2% or \$1,000 per trade and 6% or \$3,000 for the account as a whole.

2. Several days later he sees a very attractive stock A, figures out where to put his stop, and buys a position that puts \$1,000, or 2% of his equity, at risk.

3. A few days later he sees a stock B, and puts on a similar trade, risking another \$1,000.

4. By the end of the week he sees a stock C, and buys it, risking another \$1,000.

5. The next week he sees a stock D, more attractive than any of the three above. May he buy it? No, he may not, because his account is already exposed to 6% risk. He has three open trades, risking 2% on each, which means he may lose 6% if the market turns against him. The 6% Rule prohibits him from taking any more risks at this time.

6. A few days later, the stock A rallies and the trader moves his stop above breakeven. Stock D, which he wasn’t allowed to trade just a few days ago, still looks very attractive. May he buy it now? Yes, he may, because his current risk is only 4% of his account. He is risking 2% in stock B and another 2% in stock C, but nothing in stock A, because its stop is above breakeven. The trader buys stock D, risking another \$1,000 or 2%.

7. Later in the week, the trader sees stock E, which looks very bullish. May he buy it? Not according to the 6% Rule because his account is already exposed to a combined risk of 6% in stocks B, C, and D (there is no longer a risk in stock A). He may not buy stock E.

8. A few days later, stock B hits its stop. Stock E still looks attractive. May he buy it? No, since he already lost 2% on stock B and has a 4% exposure to risk in stocks C and D. Adding another position at this time would expose him to more than 6% risk per month.

Three open trades isn’t a lot of diversification. If you wish to make more trades, set your risk per trade at less than 2%. For example, if you risk only 1% of your account equity on any trade, you may open up to six positions before maxing out at the 6% limit. In trading a large account, I use the 6% Rule but tighten the 2% Rule to well under 1%.

The 6% Rule allows you to increase your trading size when you’re on a winning streak but makes you stop trading early in a losing streak. When markets move in your favor, you can move your stops to breakeven and have more available risk for new trades. On the other hand, if your positions start going against you and hitting stops, you’ll quickly stop trading and save the bulk of your account for a fresh start next month.

The 2% Rule and the 6% Rule provide guidelines for pyramiding—adding to winning positions. If you buy a stock and it climbs high enough to raise your stop above breakeven, then you may buy more of the same stock, as long as the risk on the new position is no more than 2% of your account equity and your total account risk is less than 6%. Handle each addition as a separate trade.

Many traders go through emotional swings, feeling elated at the highs and gloomy at the lows. Those mood swings will not help you trade, just the opposite. It is better to invest your energy in risk control. The 2% and the 6% Rules will convert your good intentions into the reality of safer trading.

A Comeback from a Drawdown

When the level of risk goes up, our ability to perform goes down. Beginners make money on small trades, start feeling confident, and jack up trade size. That’s when they start losing. The increased level of risk on bigger positions makes them stiffer and less nimble, and that’s all it takes to fall behind.

I saw a great example of that while running a psychological training group for a day-trading firm in New York. That firm taught its traders a proprietary stock trading system and let them trade the firm’s capital on a profit-sharing basis. Their two top traders were making up to a million dollars a month; others made much smaller profits but quite a few lost money. The firm’s owner asked me to come and help losing traders.

They were shocked to hear that a psychiatrist was coming and loudly protested they “weren’t crazy.” The owner provided the motivation by telling his worst performers they had to participate—or else leave the firm. After six weeks, the results were such that we had a waiting list for the second group.

Since the company taught traders its own system, we focused on psychology and risk control. In one of our first meetings, a trader complained that he had lost money each day for the past 13 days. His manager, who sat in on our meetings, confirmed that the fellow was using the firm’s system but couldn’t make any money. I began by saying that I’d take off my hat for anyone who lost 13 days in a row and had the emotional strength to come in and trade the next morning. I asked the man how many shares he traded, since the firm set a maximum for each trader. He was permitted to buy or sell up to 700 shares at a clip, but voluntarily reduced it to 500.

I told him to drop his size down to 100 shares until he had a week with more winning days than losing and was profitable overall. Once he cleared that hurdle for two weeks in a row, he could go up to trading 200 shares at a clip. Then, after another 2-week profitable period, he could go up to 300 shares, and so on. He was allowed a 100 share increment after two weeks of profitable trading, but if he had a single losing week, he’d have to drop back to the previous level. In other words, he had to start small, increase the size slowly, but drop it fast in case of trouble.

The trader loudly objected that 100 shares weren’t enough to make money. I told him to stop kidding himself, since by trading 500 shares he wasn’t making any money either, and he reluctantly agreed. When we met a week later he reported that he had four profitable days and was profitable overall. He made very little money because of the 100 share size, but he was ahead of the game. He continued to make money during the next week and then stepped up to 200 shares. After another profitable week he asked, “Doc, do you think this could be psychological?” The group roared.

Why would a man lose while trading 500 shares, but make money trading 100 or 200? I took a \$10 bill out of my pocket and asked whether anyone in our group would like to earn it by climbing on top of our long and narrow conference table and walking from one end to the other. Several hands went up. Wait, I said, I have a better offer. I’ll give \$1,000 cash to anyone who comes with me up to the roof of our 10-story office building and uses a board as wide as this table to walk to the roof of another 10-story building across the boulevard. No volunteers.

I started egging on the group—the board will be sturdy, we’ll do it on a windless day, I’ll pay \$1,000 cash on the spot. The physical challenge would be the same as walking on the conference table, but the reward so much greater. Still no takers. Why? Because if you lose your balance on the table, you’ll jump down a couple of feet and land on the carpet. If you lose your balance between two rooftops, you’d be splattered on the asphalt.

The higher levels of risk impair our ability to perform. You need to train yourself to accept risks slowly and in well-defined steps. Depending on how actively you trade, those steps can be measured in weeks or months, but the principle remains the same—you need to be profitable during two units of time to go up a step in your risk size. If you lose money during one unit of time, drop down a step in your risk size. This is especially useful for people who want to return to trading after a bad drawdown. You need to gradually work your way back into trading, without an upsurge of fear.

Most beginners are in a hurry to make a killing, but guess who gets killed. Unscrupulous brokers promote overtrading to generate commissions. Some stockbrokers outside the United States offer a “shoulder” of 10:1, allowing you to buy \$10,000 worth of stock for every \$1,000 you deposit with the firm. Some forex houses offer a deadly “shoulder” of 100:1 and even 400:1.

Putting on a trade is like diving for treasure. There is gold on the ocean floor, but as you scoop it up, remember to glance at your air gauge. The ocean floor is littered with the remains of divers who saw great opportunities but ran out of air. A professional diver always thinks about his air supply. If he doesn’t get any gold today, he’ll go for it tomorrow. He needs to survive and dive again. Beginners kill themselves by running out of air. The lure of free gold is too strong.

Free gold! It reminds me of a Russian saying—the only free thing is this world is cheese in a mousetrap. Successful traders survive and prosper thanks to their discipline. The 2% Rule will keep you safe from the sharks, while the 6% Rule will save you from the piranhas. If you follow these rules and have a reasonable trading system, you’ll be miles ahead of your competitors.

It used to puzzle me why institutional traders as a group performed so much better than private traders. An average private trader in the United States is a 50-year-old married, college-educated man, often a business owner or a professional. You would think this thoughtful, computer-literate, book-reading individual would run circles around some loud 23-year-old who used to play ball in college and hasn’t read a book since his junior year. In reality, institutional traders as a group outperform private traders year after year. Is it because of their fast reflexes? Not really, because young private traders perform no better than older ones. Nor do institutional traders win because of training, which is skimpy in most firms.

A curious fact: when successful institutional traders go out on their own, most of them lose money. They may lease the same gear, trade the same system, and stay in touch with their contacts, but still fail. After a few months, most cowboys are back in head-hunters’ offices, looking for a trading job. How come they could make money for the firms but not for themselves?

When an institutional trader quits his firm, he leaves behind his manager, the person in charge of discipline and risk control. That manager sets the maximum risk per trade. It is similar to what a private trader can do with the 2% Rule. Firms operate from huge capital bases and their risk limits are much higher in dollar terms but tiny in percentage terms. A trader who violates his risk limit is fired. A private trader can break the 2% Rule and nobody will know, but an institutional manager watches his traders like a hawk. A private trader can throw confirmation slips in a shoebox, but a trading manager quickly gets rid of impulsive people. He enforces discipline that saves institutional traders from disastrous losses, which destroy many private accounts.

In addition to setting a risk limit per trade, a manager sets the maximum allowed monthly drawdown for each trader. When an employee sinks to that level, his trading privileges are suspended for the rest of the month. A trading manager breaks his traders’ losing streaks by forcing them to stop trading if they reach their monthly loss limit. Imagine being in a room with co-workers who actively trade, while you sharpen pencils and get asked to run out for sandwiches. Traders do all in their power to avoid being in that spot. This social pressure creates a serious incentive not to lose.

People who leave institutions know how to trade, but their discipline is often external, not internal. They quickly lose money without their managers. Private traders have no managers. This is why you need to become your own manager. The 2% Rule will save you from disastrous losses, while the 6% Rule will save you from a series of losses. The 6% Rule will force you to do something most people cannot do until it’s too late—break a losing streak.