Saturday, January 04, 2014

Pitfalls when bumping up your equity

One thing I have found is that, when starting out using a new system or approach, people will generally only risk a small level of equity until they get comfortable with that method. Only after that point will they commit their full trading equity to the system. There's nothing wrong with that, as trend following (or any trading methodology for that matter) can take time getting used to. However, there are a couple of pitfalls you need to consider when doing this.

The first is the psychological aspect. This was brought home again with a recent conversation with a trader, who initially put in a nominal amount to their trading account while they got familiar with the system. Once he had gone through that phase, he upped his trading stake. Immediately, he found that, while each trade was still the same in percentage terms (in his case, 2% of his equity), in monetary terms the amounts involved were much bigger, and psychologically he found this difficult to deal with.

Say for example you initially committed £10,000 to a trading strategy as your initial equity, and then after 3 months or so you upped this to say £50,000. While each trade would still be a 2% risk to equity, you would have, at a stroke, increased the monetary amount at risk from £200 to £1,000. By doing that, you have cranked up the pressure by 5 times. It's still a 1R trade, or 2% of your equity, but will your mind let you stick to the system rules following this big jump in the amount risked?

In theory, your approach should be the same regardless of your equity. Whether you have equity of £10,000, £100,000 or even £1,000,000, you are only risking the same in percentage terms relative to that level of cash. But the mind may cause you to start deviating from the system. For example, you may start taking profits too early (for fear of losing them) as the monetary amounts involved are far bigger - this would destroy the positive expectancy the system may have.

There is another problem with doing this. Say you start with a £10,000 account and make some initial profits equating to say 10R. There will be an element of compounding here but you may have made £2,000 - £3,000 profit. You now pronounce that you are comfortable with the system, can see it works, and decide to bump up your equity to £50,000. By using the same percentage risk per trade, it is possible that just 2 losing trades may wipe out those accumulated profits, simply as a result of the big jump in the monetary value of your positions. In terms of R, you would still be up by say 8R (being the 10R profits made before, less the two losing trades of 1R each), but in actual monetary terms you have made a loss. This can also throw out some performance metrics that you may be using.

If you go down this route, you need to be aware of these issues, and try and divorce yourself from solely looking at profits and losses in terms of monetary value. You would be far better looking at your trading results in terms of R, and comparing the rewards against your risk. There's more on looking at your trading results in terms of R here.

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