Sunday, February 08, 2015

A tale of two traders and risk

Imagine two traders, who are looking at the same potential set up, and are supposedly using exactly the same method, with the same expectancy, to determine their entries and exits.

Trader A risks 10% of equity on every trade. He takes the signal, and ends up generating a +3R profit on the trade before taking his profits off the table, for fear of losing them.

Trader B on the other hand, only risks 2% of his equity on each position. He also takes the same entry, and lets the trade play itself out fully before an exit signal is given. He holds the position for much longer than Trader A, and he makes a +7R profit.

Trader A has made more than double (in monetary terms) than that of Trader B. So was it a better trade?

To experienced traders, the answer should clearly be No. Trader A was risking far too much of his equity on a single trade, and probably because of that, he was unable to follow his rules for exiting a profitable trade. Therefore, he got out of the position far too early. Yet he has made way more money on that trade than Trader B.

It is scenarios like this that make it difficult to quantify the quality of a trade when you talk purely in terms of the monetary gain. You need to consider other factors, such as the result in terms of R, and also the trading efficiency (i.e. were you able to follow your rules for entry, position size, and subsequent exit).

Trader A may strike it lucky every once in a while, yet because of his overly aggressive approach to risk, it is only a matter of time before he suffers a major loss when a trade goes against him, losing a chunk of his equity - possibly even blowing up his account. Because of his inability to fully let trades play themselves out, he also won't get the same results (in terms of R) on his profitable trades that his method should allow him to achieve.

Trader B however knows that trading is a marathon, not a sprint. He is thinking in terms of the next 1,000 or 10,000 trades. He is not trying to become a millionaire by this time next week.  And, by having his risk per trade under control, he is able to have an 'emotional indifference' towards the trade. This allows him to simply follow his rules to the letter without hope, fear, greed etc., clouding his decision making and his execution.

In monetary terms then, Trader B may not be the big winner on that one trade, but he will be the big winner in the long run.

5 comments:

  1. By 2% and 10% equity risk per trade/position, do you mean (using the 10% risk) allotting 10% of equity account per position, or having the initial stop placed on each trade/position so that if its hit the trade will have lost 10% of account value?

    Thanks

    Pete

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  2. Hi Pete

    Thanks for the question. Basically it is the latter - the intended risk per trade is that based on your initial stop being hit so that you suffer a full 1R loss (in the example this would equate to either 2% or 10% of your equity). So, in the event that his stop is hit, Trader A would lose 10% of their equity on that one trade.

    Most traders risk no more than 1% or 2% of their equity on each trade - certainly the successful ones and/or those who have lasted. As Ed Seykota says, "There are old traders, there are bold traders, but there are very few old, bold traders".

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  3. Thanks Steve, that's what I thought you meant, just wanted clarification. While on that subject, assume a trader has ten open positions with 2% risk on each. Portfolio heat then would be 20% risk. Another flash crash or fat thumb incident and could be a lot worse of course with massive gap downs. That of course brings up the subject of just what is a prudent portfolio heat or risk one should allow for. Maybe a .5% risk per position is more prudent, at least on initial entry with a partial position size, then add to position and bring the stop up. The position size needs to be large enough to be meaningful if it starts a good trend.

    Pete

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  4. Each trader will have their own view of what is aggressive or conservative. That said, I agree that portfolio heat needs to be adequately controlled. My turnover of trades is quite high given my aggressive cutting of any losing trades - I basically do not keep losing trades open for more than a day or two, before I get out. Also, I have strict limits on the number of trades that can be held at any time. Some of the ways I seek to control risk are shown on the recent blog post '10 Ways to control risk'.

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