Risk Management

The risk-reducing formulas behind portfolio theory rely on a number of demanding and ultimately unfounded premises. First, they suggest that price changes are statistically independent from one another...The second assumption is that price changes are distributed in a pattern that conforms to a standard bell curve. Does financial data neatly conform to such assumptions? Of course, they never do.Benoit B. Mandelbrot

Suppose you have two traders each following the same trading system. The system produces a signal to buy Microsoft stock. The first trader initiates right when he must, based on the system, but for some reason, the second trader misses the signal. The market now goes up in the desired direction boosting the value of Microsoft stock. The second trader finally initiates and buys Microsoft stock, but obviously later than the first trader. Two questions: Should the second trader make the trade since he missed the signal the first time around? And if the second trader does, isn't he still missing out on potential profit since he got in later than the first trader?

Now let's say that, instead of just the same system, the two traders have the same amount of money. Two more questions: Doesn't this scenario imply that the first trader who got in at the right time is risking more money since the second trader still got in the trade but did not have to do so as early as the first trader? Doesn't the second trader have an advantage since he is risking less?

The answer to each of these questions is the same. Both traders are in the same position. Both have the same advantage. Great traders avoid personalizing their trading as it blinds them to the reality of what is actually happening in the market. The market is the market whether you participate or not, so personal circumstances don't matter. Both traders are in the same situation, in the same market with the same position, with the same money and the same attitude. Why must these two traders act differently just because one has a slightly different past in terms of when he entered the trade?

Followup

This article has caused some confusion among readers. Reader feedback:

• But, timing is crucial.
• Stops are money management.

Timing of entry is not the critical issue in overall trading success (it is maybe 10% of your overall success). Additionally, money management (which is widely misunderstood) is much more than stop placement. Placing a stop does not tell you how much to buy or sell.

NOTE: If you want to learn trend following techniques and systems through advanced home study and or seminars for all traders click here. If you want to learn about trend following trading in general there is one definitive text the bestselling classic "Trend Following: Learn to Make Millions in Up or Down Markets" by Michael Covel. If you want to learn about the most famous group of trained trend following traders, the Turtles and their teacher Richard Dennis, "The Complete TurtleTrader" by Michael Covel is the only complete biography (with all of the Turtle rules) available. If you have any questions you can reach us immediately via phone or email.

So how much thought have you given to money management recently? Or are you still too preoccupied by all kinds of indicators or fundamental buy, sell and holds to focus on the subject?

Eventually, however, you've got to ask yourself the most important question of all: "how much?" right?

Getting a straight answer to that one may be tough. There's still a lot of confusion about risk or money management from so-called gurus. I recently saw the following comment regarding money management from a "guru":

"[We] use very simple money management: Trade one contract per trading signal in the markets … with no pyramiding."

This is NOT money management. When you hear someone describe money management like this trading guru, run don't walk the other direction as you are about to be conned.

So if money management isn't some set amount of shares or contracts picked out of thin air, what is it? Money management answers the question of "how much?" At all times, given the risk you are taking, the money you have, and the volatility of the market -- you must know the optimal number of shares or contracts to be long or short.

In my opinion money management or position sizing or bet sizing just doesn't get the attention it deserves. Gibbons Burke of MarketHistory.com observes:

"Money management is like sex. Everyone does it one way or another, but not many like to talk about it and some do it better than others. But there's a big difference: Sex sites on the Web proliferate, while sites devoted to the art and science of money management are somewhat difficult to find."

Money management is ultimately a defensive concept. It keeps you in the game. For example, money management tells you whether you have enough new money to trade additional positions. Trend followers all realize that you need to make small bets initially to simply stay alive and play another day. So, if you start at $100,000, and you're going to risk 2 percent, that will be $2,000. You say to yourself, "Why am I only risking $2,000. That's nothing compared to what I've got to bet." But that's not the point. First things first. You can't predict where the trend is going to go, so you can't afford to risk all of your capital out of the gate. Trend follower Craig Pauley points out:

"There are traders who are unwilling to risk more than 1% but I would find it surprising to hear of any trader who risks more than 5% of assets per trace. Bear in mind that risking too little doesn't give the market the opportunity to allow your profitable trade to occur."

Think about money management as you would about getting into physical shape. You can't lift weights six times a day for hours each day for 30 straight days without hurting yourself. There's an optimum amount of lifting you can do per day that gets you ahead without setting you back. You want to be at that optimal point just as you want to get to an optimal point with money management. Trend follower, Ed Seykota, author of The Trading Tribe book, describes this optimal point with his concept of "heat".

"Placing a trade with a predetermined stop-loss point can be compared to placing a bet. The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure - or heat - from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. In portfolio management, we call the distributed bet size the heat of the portfolio."

Trading correctly is 90% money management, a fact that most people want to avoid or don't understand. However once you have money management down, your personal psychology will be 100% of your trading success. Once you have the rules, you still need to follow them!

Why then do traders have such trouble keeping their trading proportional? Why is it so hard for them to find that optimal point? Fear. Trend follower Tom Basso points out that traders usually begin trading small and then as they get more confident increase their trading size. Once they get to a certain comfort level of say, 1000 contracts, they often stay there, suddenly fearful that turning up the "heat", to use Seykota's term, will increase their risk. For trend followers like Basso, the goal is to keep things on constant leverage.

Few traders make the move to a proactive posture in which risks are actively managed for a more efficient use of capital. How do you avoid trading less instead of trading the optimal amount at whatever capital you have? You need to create an abstract money world. Don't think about what money can buy. Just look at the numbers like you would when playing a board game like monopoly or risk.

And since your capital is always changing, it's important to continually rebalance your portfolio. Trend follower Paul Mulvaney points out that, "Trend following is implicitly clear about dynamic re-balancing which is why I think successful traders appear to be fearless. Many hedge fund methodologies make risk management a separate endeavor. In Trend Following it is part of the internal logic of the investment process."

There it is: the key is a risk understanding. That's what money management is really all about. Managing risk.

When any trader makes a decision to buy or sell (short), they must also decide at that time how many shares or contracts to buy or sell — the order form on every brokerage page has a blank spot where the size of the order is specified. The essence of risk management is making a logical ...

It is a common notion that after you have profits from your original equity, you can start taking even greater risks because now you are playing with their money. We are sure you have heard this. Once you have profit, you're playing with their money. It's a comforting thought. It certainly ...

Many hear the word correlation and they go to sleep. You can't sleep though -- it's too important to grasp. Definition:

Correlation coefficients gauge how closely an advisor's performance resembles another advisor. Values exceeding 0.66 may be viewed as having significant positive performance correlation. And consequently, values exceeding -0.66 may be viewed as having significant negative performance correlation.

What are some examples of correlation in action?

• Example Chart #1
• Example Chart #2
• Example Chart #3

Source: CSI Data

Why Useful?

Just what is correlation, and how do we derive the correlation coefficient? Correlation is a statistical term giving the strength of linear relationship between two random variables. More simply defined, it is the historical tendency of one thing to move in tandem with another. The correlation coefficient can be a number from -1 to +1, with -1 being the perfectly opposite behavior of two investments (e.g., up 5% every time the other is down 5%), and +1 reflecting identical investment results (up or down the same amount each period). The further away from +1 you get (and thus closer to -1), the better a diversifier one investment is for the other. Correlation coefficient is found by taking the covariance between two variables and dividing by the square root of the product of each of the two variances (trust us on this part). No wonder the eyes of so many glaze over when discussing the topic of correlation. However, it has some very tangible uses, if they can be explained to the novice. The most simplistic description of correlation is the tendency for one investment to “zig” while others are “zagging”.

Why then would we want to time the market, if all the studies have shown that actual client timing is so poor? The answer is that actual client timing has been driven more by investor psychology than logic. Our simple timing strategy (or more sophisticated ones used by many ...

Some mistakenly believe that Trend Following will cease to work if too many people trade as Trend Followers. We have addressed this question over the years, but decided to approach the issue from a different angle: human nature and the ...

One of the best books covering the history of risk in society is Against the Gods: The Remarkable Story of Risk. The author delves into the trading psychology (otherwise known as behavioral finance) all Trend Followers live and die by:

Imagine that you are on your way to see a Broadway play for which you have bought a ticket that cost $40. When you arrive at the theater, you discover you have lost your ticket. Would you lay out $40 for another one? Now suppose instead that you plan to buy the ticket when you arrive at the theater. As you step up to the box office, you find that you have $40 less in your pocket than you thought you had when you left home. Would you still buy the ticket? In both cases, whether you lost the ticket or lost the $40, you would be out a total of $80 if you decided to see the show. You would be out only $40 if you abandoned the show and went home. Kahneman and Tversky found that most people would be reluctant to spend $40 to replace the lost ticket, while about the same number would be perfectly willing to lay out a second $40 to buy the ticket even though they had lost the original $40. This is a clear case of the failure of invariance. If $80 is more than you want to spend on the theater, you should neither replace the ticket in the first instance nor buy the ticket in the second. If, on the other hand, you are willing to spend $80 on going to the theater, you should be just as willing to replace the lost ticket as you are to spend $40 on the ticket despite the disappearance of the original $40. There is no difference other than in accounting conventions between a cost and a loss. Prospect Theory suggests that the inconsistent responses to these choices result from two separate mental accounts, one for going to the theater, and one for putting the $40 to other uses--next month's lunch money, for example. The theater account was charged $40 when the ticket was purchased, depleting that account. The lost $40 was charged to next month's lunch money, which has nothing to do with the theater account and is off in the future anyway. Consequently, the theater account is still awaiting its $40 charge.
Against the Gods: The Remarkable Story of Risk

Trend Followers do not allow themselves to create these artificial accounts. They always work to eliminate discretion by relying on the pure numbers. Great traders know their secret is their objectivity.

On Ed Seykota's web site he was once asked about using index cards with charts. The reader wanted to know how that worked. Ed responded:

You can use index cards with charts; use a card to cover up the right side of the graph, and reveal it to yourself one day at a time, ...