The Art and Science of Risk Management

[Leth]

Risk, put simply, is the possibility of loss.

Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources.
The strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk.

-Wikipedia

Now that we know the definition of risk, you are probably wondering what it means to actually manage it. We can do this by applying 6 different psychological rules to our overall trading ability:

1. Cut losses
2. Ride winners
3. Trade with the trend.
4. Keep your bets small
5. Diversify
6. Always follow your rules

These rules appear simple, however, due to human nature, they are the most difficult to follow. For the sake of education, lets perform a simple disection of each rule.


Cutting Losses

If the price starts to trend in the opposite direction of our long/short position; get out! Recognizing the importance of this rule is one thing, following it is another. Why; because people have a tendency to want to be right in their decisions. For instance, if you take a long position on a equity/commodity, you are obviously looking for it to go up. As soon as your position begins to go against you, human nature takes over and hope starts to rear its ugly head. Hope is a deadly emotion in the trading arena. Therefore, its never too late to ask yourself the question: Why would I want to average losers (not cutting losses) when its more productive to average winners?


Ride Winners

If price is moving in the right direction of your long/short position; why not just stay in? No one can actually know when a winning trade will end. Not knowing, yet wanting to know, how far your position will continue to go up or down is a symptom of fear. However, realizing that it’s impossible to predict market direction will help keep your fear in check. This line of thought is considered contrary to systems that set profit targets and adopt the following mantra, “you can’t go broke taking a profit.” Only you can decide which philosophy is right for you.


Trade with the Trend

In the northern hemisphere, rivers flow from north to south. In the southern hemisphere, they flow south to north. Either way, they will continue to flow in thier natural direction no matter where you're located on the globe. So whether you decide to kayak down the Colorado River or Up the Nile River; isn’t it just easier to go with the flow. Trading can be viewed the same way. Markets trend up, down, or sideways, no matter how you decide to trade them. If you don’t believe this, see how profitable you become by going against the market. Why buck the trend? “Everything flows.” – Heraclitus


Keep your bets small

In managing risk, it’s important to know at all times how much of your total trading capital you’re going to bet on a single trade.

For example, you might bet only 2% of your total capital on a particular equity/commodity. Let's say you also want to add to your risk management by not having anymore than 40% of your total trading capital in the market at one time (this depends on whether your system is designed to be "always in the market"). All you have to do is choose 20 different equities/commodities and bet no more than 2% on each single equity/commodity trade. The math is simple: 20 equities/commodities multiplied by 2% of total capital per trade = 40%

Maybe you want to trade 40 equities/commodities and bet 1% of your total capital per trade. You get the same outcome: 40 equities/commodities multiplied by 1% of total capital per trade = 40%

If you lose all 20 or 40 of your trades in a row, the odds of which are considered slim to none, you still have 60-80% of your original trading capital left to play with. Is this a bad thing? Of course not. Why; because you’re still in the game. Betting the ranch on a single trade is a sure fire way to view the game from the sidelines. Who wants to do that? I don't know about you, but I'd rather be making money.


Diversify

Diversification distributes your investments among different markets/equities in order to limit losses in the event of a fall in an individual market/equity. The strategy relies on the market/equity having a profitable expected value, or probable payoff.

Diversification also offers psychological benefits to single market/equity trading since some of the short-term variation in one market/equity can cancel out that from another market/equity and result in an overall smoothing of short-term portfolio volatility.

An example of diversity:

Suppose your trading a few NASDAQ (technology) stocks. Your portfolio may include both Dell and Gateway. Would this be considered diverse? No. Because both companies are in the same sector; which means both equities are likely to go up and down simultaneously even if they are at different prices. So, if you’re in a long position and the computer sector drops suddenly, both stocks may lose money at the same time.

However, if you are trading a computer stock and a software stock (e.g. Dell and Adobe), your probability of making money is higher. What do I mean by this? If Dell goes down and hits your stop, you cut your loss. Since Adobe is in a different sector (software), the stock may continue to trend upward which may make up for your small loss on Dell and possibly even show you a profit in the end.


Always follow your rules

Using rules can:

1. Help us make sound trading decisions, and
2. Balance our psychological threshold when dealing with risk.

The reason why 95% of all traders fail to succeed is because they do not have the discipline to follow rules. If this statement is true, we can then conclude that the other 5% are successful because they do follow rules.

Being able to follow your own rules and to think in terms of probabilities will not only help you grow as a trader, but also as an individual. Of course, thinking in terms of probabilities is a whole different subject.

[daytraderB]

Your article hits right on target. Successful traders know they wake up every morning being possible losers, and adapt to that. Failing traders have a problem admitting the markets are always right. As a result, they refuse or postpone taking a loss and end up wiping their accounts.

Being able to follow your rules also separates true traders from wannabes. Great article!