What is the main difference between an experienced trader and a new trader? It’s not a trick question. One has been in the markets for a period of time while the other has not. A bit too obvious surely? But there’s a deeper truth in this answer than might at first appear.
Let’s assume that both experienced and new traders are interested in being in the market and that both want to make money. What stops the new traders from becoming, over time, experienced traders? The answer is being unable to stay in the market because they lose their trading fund. And there is an insight. Experienced traders are those who have not lost their trading fund.
So experienced traders know that the reason they are still in the market is that they did not lose money. So that’s what they focus on because they want to ensure that they stay in the market. But what do new traders focus on? Making money. That’s the crucial difference. Experienced traders ensure they avoid losing money through good risk control. So money management must be the first requirement for any trader.
The importance of controlling risk is stressed by a number of the authors of my favourite books on trading, in particular Alexander Elder and Van Tharp. It’s not going too far to say that these authors place controlling risk above all other aspects of trading methodology.
My own approach is fairly simple. I identify the stop and target, which also allows me to assess the risk reward ratio, before I enter any trade. It is important to identify the stop position before looking at risk. This is to ensure that the stop is set in accordance with whatever rules for managing the trade are being used and what is seen on the chart in terms of support or resistance or other relevant information, rather than setting the stop to allow a particular position size to be taken without exceeding the risk allowance. I then choose the position size that will limit the risk on any trade to under 2% of my trading capital. These are simple calculations. This ensures that the maximum risk on any trade is controlled.
Alexander Elder describes two types of calamities that can befall a trader: death by piranha bites and death by shark bites. All the above comes under the heading of the shark bite – the danger that a single catastrophic loss will decimate the fund. Keeping risk per trade below 2% of your trading fund will avoid this. Piranha bites refer to the danger that a portfolio can be eaten away by a lot of relatively small losses.
Elder’s recommendation to avoid this is to monitor total losses in any month and if these exceed 6% of the fund’s value then cease trading for that month. I’m not totally sure if all open trades should be closed, but certainly no new trades should be opened. His reasoning is that there is clearly something wrong either with the analysis, or the market or the trader’s thought process and so it’s best to just get away from the markets for a while and then start anew with most of the portfolio still intact.
This might be good advice sometimes, but I’m not totally convinced. Instead I concentrate on controlling total open risk, in other words, if there is a certain percentage of risk open then I won’t enter any more trades. Having said this, if I experienced a drawdown of, say, 10% in a short period then I would likely back away for a while.
The aggregation of the risk in all open trades can be considered to be the total portfolio risk and a question arises as to how great this should be. There is no simple answer as it depends on how correlated the various trades in the portfolio are. Measuring this accurately is not simple and might be beyond the requirements of individual traders and my advice is not to get overly hung up on this. Instead I use a few simple assumptions and rules.
If there are two trades open in the same security using the same set-up then the total risk for these trades must not exceed 2%. This means that if I open a trade with risk of 2% then I cannot open a further trade in that security unless and until I have moved my stop up closer to the entry level. This also ensures I will never ‘average down’. However, if I am using two very different set-ups – let’s say there is a swing trade open with an expected time horizon of a few weeks and I wish to open a day trade that I will definitely not hold overnight – then I will allow a total risk of 3% for these two trades. The reasoning is that, although the security’s price in the two trades is obviously 100% correlated, a move that might be large relative to the distance to the stop in the day trade will be relatively small in terms of the longer term trade.
If there are two trades in different equities in the same overall market then I assume a 65% correlation. Therefore, once the risk on each trade is below 2% as it must be, the total risk is the sum multiplied by 0.65. This is based on a general view that approximately 65% of a stock movement is due to overall market movement. Of course, if the two stocks are closely associated in some manner or in the same sector then it would be prudent to assume 100% correlation.
This is important since it is necessary to control total portfolio risk. After all, even if the portfolio comprises trades in quite different stocks and a couple of currencies, it is conceivable that a sudden market move could move all against me. The is no simple answer to address this, and trader discretion based on experience is required.
As a general rule I would not wish for total portfolio risk, adjusted if you wish for a correlation factor in the region of 65 to 100%, to exceed 15 to 20% of the trading fund. I would only allow it to move towards the higher end of this range if there were a number of day trades included or if the volatility in the market was low. For example, if the VIX was moving within a well defined range below 20. I would also want the total to be considerably lower over a weekend if there were Forex trades open as these can gap when the Asian markets open on Sunday night.
Despite all this, there are a few loose ends that can cause questions to remain in traders’ minds. One of the most important arises when a trade is in profit and the stop has been moved to the entry level so, in the way it has been discussed so far, there is no risk open. And yet, if the trade was closed now, the profit would be booked, whereas leaving it open introduces the risk that some or all of the profit could be lost. Clearly there is a risk associated with this trade but it is qualitatively different. To recognise this difference I term this ‘trade risk’ whereas the previous risk i.e. the potential loss when the trade is opened, is ‘fund risk’.
There does not seem to be much consensus among writers on how this should be managed. The 2% rule is not appropriate here as it could cause a stop to be moved too close and be hit by a temporary spike in the market. A common rule appears to be to move the stop to ensure that a certain percentage of the profits are protected – this percentage usually lies in the region of 50 to 75% depending on whose work you are reading. This is not a bad approach but, again, it is important that following this rule does not lead to moving the stop too close. An alternative might be to take partial profits by selling some of the stake but this introduces its own risk as it means that you risk losing out on further gains.
It’s not easy, but I emphasise the importance of not moving the stop to protect profits and setting it at an inappropriate level. So always set the stop according to rules regarding the chart pattern. Again, I try to manage this risk by looking at total risk including both fund risk and trade risk. In other words, I look at the total that could be lost from the current value of the fund, including any unrealised profits, and see if I am comfortable with this. After all, it might be better to reduce this through exiting a poorly performing trade than risking being stopped out of a good trade in profit as a result of moving a stop too close.
I don’t like to see total trade risk exceed 25% of the fund. This may seem excessive, but it includes unrealised profits and so this is not putting 25% of my fund at risk in the way in which this is usually considered. Also, I will take a simple aggregation and ignore any correlation factors.
This might seem like there are a lot of calculations required but it is very easy to set up a spreadsheet to keep a running total of the open risk. And you should have this in place. In any case, it is probably not a good idea to have trades in more than 10 or 12 instruments open at any time and so the calculation can be done fairly quickly anyway.
Remember, controlling your risk is at least as important as the methodology you use to identify trade opportunities and entries, but even following all these rules the time required will still only amount to a fraction of the time that most traders apply to finding trades.