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Risk: What’s the worst that can happen?

Dont risk too much on your tradesI had been trading for several years before I saw the Dr Pepper “What’s the worst that could happen?” ad campaign.

I immediately thought about trading risk and asked myself how I could protect my capital if the worst were to happen.

It was only a year earlier that Nassim Nicholas Taleb had published his bestselling book “The Black Swan”. A black swan event is one that occurs unexpectedly and has a major impact, such as a stock market crash.

In trading you have to protect yourself against black swan events and to do that you have to ask yourself: what’s the worst that could happen?

Expect the unexpected

As a longer term trend trader I can experience prolonged periods of standing aside from taking new trades. Then, like buses, several trades come along at once.

Most trading textbooks will tell you to risk a maximum of 3% a trade, with daily limits set at say 6%, weekly at 12% and monthly limits at 18%. While this is fairly sound advice – it at least gets the trader thinking about total exposure – the markets for trend traders can be a little more sporadic.

Trying to take weekly, monthly or even quarterly targets from the market is keeping people in the ‘employed’ mentality. As an employee workers can expect the same remuneration every week or month regardless of whether they work extra hard, take it a little easy, take days off sick or even take a holiday.

TDT Tip: Trading is more like running your own business. Like the seasons you will experience long, cold winters, mild winters, heatwaves, thunderstorms, April showers and Indian summers. No two years are the same, so no two weeks or months can be expected to be the same, either. Setting yourself weekly or monthly targets is setting yourself up to fail.

You need to have a little flexibility with your risk exposure and having limits on your risk by day, week or month can seriously hamper your ability to take advantage of the trends when they happen.

Total risk – the worst that could happen

Many trading textbooks will begin with looking at risk per trade but we need to turn that on its head. If a black swan event occurred and all your trades were wiped out, how much of your account could you afford to lose – and still be in the game?

I know it seems unlikely that all trades would be stopped out, but that’s the nature of the unexpected. So we have to make allowances for it.

Paradoxically, the larger your trading account the less you want to lose. Twenty percent is twenty percent but, illogical as it is, 20% of £1 million seems a lot more than 20% of £1,000. Especially if you have spent years building your account up.

Therefore, as your account grows you may want to adjust your risk portfolio. However, 20% is a good starting point. I wouldn’t recommend any more than that and, if your account is fairly large, you may want to reduce this to 15% or even 10%.

Correlated trades

Rather than set daily, weekly and monthly risk maximums, I prefer to look at correlated trades.

Correlated trades really relate to markets that tend to move in tandem. For example, gold and the US Dollar, or mining stocks and their affiliated commodity.

But I also put in this category overexposure in related markets. For example, trading too many stocks in the same sector, or too many of the same base currency crosses.

So if the Japanese Yen is on the move then select only two or three of the best looking Yen crosses to trade – don’t go into all of them. And if the S&P is on a major bull run – led by technology stocks – then make sure you limit yourself to a few of the best tech stocks (and consider other stocks which are outperforming their industry, too).

It also makes sense to be active in several markets. Part of this is because, as a trend trader, there will be times when certain markets just aren’t trending well enough to trade them. Although you are active in the market – in that you are watching and waiting – your position is standing aside.  While this is excellent for protecting your capital it doesn’t help to grow it. So you need to be able to follow and move the money.

TDT Tip: Institutional funds are often at least partially invested at any one time. This means that if one market is underperforming they have to invest in another market. They don’t have the same luxury of standing aside, as private traders do. But what this means is that the big money moves around and we need to move with it – if we can.

I find that by covering currency, US stocks and a few commodities I can usually find a good trend somewhere.  Limiting yourself to one market can be a frustrating test of your patience.

Not all trades are equal

One essential part of risk management is deciding how much of your account you can risk per trade. As I said before, start with an apocalyptic event scenario then backtrack to work out the maximum number of trades you feel you could manage comfortably.

If trading is a part-time activity for you I would say 20 in-play trades at any one time would be a maximum. If you are new to trading it should be considerably fewer.

To take this as an example: if you plan on having a maximum of 10 trades in play at any one time – and your black swan protection limits your risk exposure to 20% of your account – you can risk up to 2% of your account per trade.

20% / 10 = 2%

However, there is no rule that says that you need to take the whole 2% allocation. At the beginning of a trend you may want to test the water with 1%, or even less.

If your account is small you may not have this option, but it is something you should consider as your account grows.

Some trade set-ups will be better than others. For the ones where you have full confidence then allocate your full risk.  For the ones that are a little more “maybe” allocate half or quarter risk.

TDT Tip: However good the set-up, there is no guarantee of success. See my blog You can’t be a winner without being a loser”.

Limiting yourself to 10 trades at a time has another advantage – you’ve only going to pick the very best opportunities.

Quality not quantity

Twenty trades is at the ceiling of manageability. I define one trade as one stock, currency pair, or commodity – not the number of positions I may have on the trade. If a trade is going well you should add to your position – make sure this is part of your strategy and/or trade management system.

TDT Tip: With longer-term trend trading no more than ten trades is actually quite normal. In fact, you only need to catch a few good trends a year to make good profits. Many trades are ‘feelers’ – a tentative dip into a recently established trade. If the trend becomes linear and neat you add to your position.  If the trend is less linear you may or may not add to it, depending on other opportunities elsewhere.

I generally have fewer than 10 trades in play at any one time. Trading, for me, should be straightforward and stress-free.  Even though I only have to check my trades once a day, I would find it difficult to track many more than ten – and still be relaxed and calm. There are times when I have more – if the markets are handing out good trades I’d be a fool to turn them away – but usually I don’t. Keeping tabs on my trades and adding positions to the successful ones is far easier than trying to find a new trend.

Conclusion

Make sure your capital is protected from an unforeseen event.  Don’t be swayed by the experts who claim they saw it coming – they are wrong more often than they are right.

Keep your total exposure to an amount you can afford to lose. Rather than take out a lot of trades, select the best performing ones and add to your position (rather than spending your time and money on less successful trades).

Keep the number of open trades to a number you can easily manage.

And finally, always be in control of your trades – because you can’t be in control of the markets.

Please feel free to leave any comments below.

Good trend trading…

Anne Chapman

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