Ask 90% of traders or investors what they focus on when putting on a trade, and they will talk about the potential returns they anticipate making. The remaining 10% of traders approach the markets from the opposite direction, and their primary concern is to control how much they can lose. It is probably no coincidence that 90% of new traders either suffer significant losses or even blow up their account within a few months.
Consideration of how much you can lose does not only refer to an individual trade, but also all your positions in total. This is where the concept of portfolio heat comes in.
You could have 2 positions open where you have risked 5% of equity per trade, or 10 positions open where you risked 1% of equity per trade – in both cases, your portfolio heat is 10% of your equity.
It is important, particularly in changeable market conditions, that you do not go from a very low heat level to a much higher one in a short period of time. To do this, try and avoid opening a whole bunch of trades in a short period of time.
It is far more preferable to gradually increase your heat levels. Put on one or two trades, observe how they react in the market, and see if you are able reduce the risk on those trades by being able to move your stops up based on your chosen method. Then, if market conditions are still favourable, then you can look to add other position that may be setting up.
What this does is keep some control on how much you can lose overall in a short period of time. Consider setting your overall risk parameters, and restricting yourself to a set number of new trades per day or per week, based on your method, preferred timeframe, market conditions etc.
Referring to this concept of portfolio heat could have helped a lot of people given the market action last week. Those who were looking to go short and take advantage of the downdraft in the indices may have piled into a number of weak looking stocks, only to see the major market averages rally strongly in the second half the week. It would have been easy to have chalked up a decent number of quick 1R losses. Having overall risk parameters and a conservative portfolio heat setting could have contained your losses.
Similarly, people earlier in the month may have jumped in and bought a number of stocks based on some ‘oversold’ indicator reading, with a view to profiting from a subsequent rally. As the saying goes, what looks cheap now may be considerably cheaper next week, next month, or several months down the line. It’s far better to dip your toe in with one or two trades, rather than plunge in to dozen or so positions all in one go. If not, then some or all of those stocks may have kept going down for a few more days resulting in a run of losing trades.
Plunging into the market and taking on a lot of risk might make you a killing once in a while, but more often than not you could lose a big chunk, if not all of your equity. It is far easier from both a financial and psychological point of view to recover from a small drawdown than a much bigger one.
The bottom line is, follow the lead of the successful traders and make sure that your primary concern is to control your portfolio heat and potential losses at all times.
Again, this is something that is entirely within your control, and does not relate to entries and exits. But ultimately, controlling when your enter the market, and how much risk you take on, can be the determining factor in whether you are successful as a trader or not.