Friday, August 26, 2011

Risk management - Tracking the trend

When talking about trend following people automatically think of the entry and exit rules with such a system.

How many traders though track the trend of their results for risk management purposes?

The theory here is that you can constantly adjust the percentage risk per trade depending on how your system is currently performing. There are various formulae designed to do this for you, some of which also factor in volatility in the instrument(s) you are trading. The bottom line is, if your system is simply not working (possibly with the market conditions not being conducive to your style of trading) then as the number of consecutive losing trades increases, the smaller you trade. As your win rate increases, then your risk per trade increases. In essence, your are trend following yourself and your results.

This is obviously the polar opposite of martingale style methods of risk management, where trade size increases the more losing trades you have. Fixed fractional risk management, which is probably the most popular style of risk management, keeps the percentage of your equity risked on each trade at a constant, and it is regularly adjusted to your current equity balance. Again, I have seen this calculated based on closed trades only, or with open profits included.

The trend following style of risk management takes this a stage further, as the percentage risked is adjusted depending on the number of consecutive wins or losses you have. This can be useful for trend followers in general, as the profits generated from such a system tend to arrive in short, sharp bursts. When a major trend is in place, you want to be trading at your most aggresive (still while controlling your overall risk parameters), whereas, in a non-trending state (espeically if combined with high volatility) your win rate is likely to be a lot lower, so you would be trading smaller during those market phases.

The area of risk managment is a veritable minefield, and you can spend hours reseaching the various basic options available to you. Again, with all things trading, you need to ensure that you are 100% happy and compatible with your risk management part of your system.

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