Wednesday, August 15, 2012

Staying in the game - risk management

It should be clear to everyone that risk management is vital to succeeding as a trader. It is possible to have a winning system, which has a positive expectancy, yet if the risk parameters are too aggressive then there is a good chance that you will suffer at best a severe drawdown, or at worst a blow up on your trading account.

Yet, everyone has a different opinion as to what they determine as being too aggressive.

For trend followers, risk control forms an inherent part of the overall system. As trend followers chase absolute returns, it is very difficult to quantify and demand a certain return from the market, within a certain timeframe. It is feasible that you can make losses over the course of the year, if the markets simply do not provide any meaningful trends. 2011 was a good example of this in the general market. Yes, there were still profitable trends in individual stocks, but they were more difficult to find. Against that 2008 on the short side, and 2009-2010 on the long side generated significant profits over several hundred percent.

Of course, you cannot predict when these good trending periods will fall. Trying to determine that you will make x% per year simply does not work, yet over a period of a number of years, with the magic of compounding you can make a large sum of money. £20,000 traded over 10 years with an average return of 30% increases your equity to approximately £275,000.

I know of trend following systems similar to my own which use a maximum position risk of 0.5% and have generated annualised returns of over 180% over 10 or 20 years.

Remember if you suffer a drawdown of say 50% in your account, then you subsequently need to make a 100% return to get back to where you started. It is also important that, if you do suffer a drawdown, that you adjust your position size (in monetary terms) in accordance with your rules. I adjust my own position size parameters for any new positions on a day by day basis, to account for any closed trades.

The other point to factor in are those situations where a stock gaps up or down through your determined stop level. These can lead to losses being suffered in excess of your risk parameters. The possibility of this (however remote) needs to be considered and allowed for when determining your position size. On the day after the 1987 stock market crash, the Turtle traders suffered huge losses as some markets reversed sharply following intervention by the US Government. Even with their position sizing rules in place (which were quite advanced at the time), their profits for the year vanished overnight.

Proper risk management allows you to ride out those periods of drawdowns and allow you to benefit when the markets give you profitable trends.

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