Friday, March 08, 2013

Different viewpoints on risk

I've had a couple of interesting discussions with other traders this week regarding the returns I have generated and my approach to risk. As I've said before, everyone has their own idea of what is conservative, or what is aggressive, position sizing.

The first trader mentioned that my profit per trade (in terms of R) was quite low for a trend following method, and on the first look it probably is. However, that is not the only metric I look at. As part of my methodology, I have a set approach to calculating my initial stop distance from my entry point. Now, I could easily place this a lot closer, however there are two factors that stop me from doing this:
  • The potential of being stopped out on the widening of the spread on the market open;
  • The potential for a gap down through my initial stop level, meaning I would incur a loss greater than my intended risk on that trade.
Of the two, the second is by far the bigger issue. Reviewing my trades, I could reduce my initial stop distance by at least half, which would potentially double my reward:risk. That is all and good, but should a stock gap through my stop level, then that loss would also be magnified.

Say I had a position in a stock which went against me following a news release, and that, by using my existing initial stop placement method, I incurred a loss of say 2R. Had I reduced the initial stop distance by half, then this would have increased my loss on that trade to 4R. If I was risking 2% per trade, then that one trade would have cost me 8% of my equity overnight.

As Paul Tudor Jones said in his Market Wizards interview, you need to play "great defence" when trading - profits will take care of themselves.

I am also reminded of how the Turtle Traders incurred massive losses the day after the 1987 stock market crash, when several positions went against them. Several months' hard earned profits evaporated on an unavoidable skid. In his book Way of The Turtle, Curtis Faith, who was one of those traders stated that he lost 65% of his equity overnight.

The second trader I spoke to about this mentioned that his returns for the year to date are a lot lower, but his drawdown this year is also lower. He is extremely risk averse, and risks only 0.5% of his equity per trade. In his own words "my whole aim in trading is to minimise risk, and hopefully the profits will take care of themselves".

Due to the changes I've made in my methodology, it is possible I have slightly curtailed my ultimate profitability, however against that my cash equity drawdown is massively reduced. As an example of this, since July I have seen an increase of almost 100% in my cash equity (the figure on the sidebar that I update regularly includes profits on any open positions). However, the biggest drawdown in cash equity on a week-by-week basis is less than 3%. In addition, the size of my average profit (in terms of R) is almost three times the size of my average losses. The fluctuations in my equity and the drawdowns suffered have significantly reduced, which helps from a psychological point of view.

While trend following is seen as an 'absolute returns' strategy, it is wrong to think that this is without sufficient regard given to risk and drawdowns, and as mentioned at the start of this post, the parameters used can vary from one trader to the next. If anything, the 'absolute returns' message is misleading, as what it actually refers to is simply the intention to try and ride the trends you are trading right up until they flash an exit signal.


  1. Hi Steve the second factor you mentioned above shouldn't be a big issue if you are using guaranteed stop loss?

  2. Hi Chris, yes the second problem is not an issue should you be able to use guaranteed stops. However a) not everyone has those available to them, and b) guaranteed stops do limit you in terms of stop placement and how close it can be to the current price. You will also find that, as your equity grows, you may enocunter difficultly in being able to use those stops on certain positions. Steve