Money Management - Percentage Risk Question

O

opmtrader

I'm wondering if anyone can help me answer a very fundamental question concerning the percentage risk in an account. Basically you hear time and time again that professional traders only risk 1% to 2% of their account on any one trade. At first I took this to mean that in each market they trade (lets say they trade 10 separate markets in their account) they risk 1% in each position in each of the 10 markets (i.e. an actual 0.1% of total account equity) adding up to a total of 1% total risk in the account. Now I am wondering if they really meant something more like risking 10% in each position in each of the 10 markets (i.e. an actual 1% of total account equity) adding up to a total of 10% risk in the account. Which one is the correct interpretation?

(1%*1/10th of the total account)*(10 markets)=1% total risk.

OR

(1%*total account)*(10 markets)=10% total risk.

I am inclined to think that it is the one on the bottom here as it would seem that a stop limit of 1% in a singular market would not be enough room to breathe especially if you were using any type of significant leverage. In my testing I have found that my percentage stops should have some relationship to the amount of leverage being used. While this relationship seems to work well on an individual basis I do know that creeping towards 10% total portfolio risk seems to be a little too risky. I am just
wondering solely from a money management point of view what is considered reasonable. Is 5% or 10% total outstanding risk in a diversified account a totally risky amount? Am I wrong about 1% not pertaining to total account risk? Any advice anyone
could give would be much appreciated as always. Thanks.
 
The 1-2% risk you hear so often is refering to your account size and how much of that total you are willing to lose if you are stopped out on the trade. If you have a $100,000 account and risk 1% on a trade, you would be down $1000 if you are stopped out. This is how you determine the proper position size and the stop order for the trade.

With a $50 stock, you could buy 5000 shares with a 20 cent stop or 500 shares with a $2 stop. Keep in mind the correlation between many open positions. If you are long 10 highly correlated stocks with 1% account risk on each of them, you are essentially long one huge position with 10% of your account at risk.
 
Opmtrader,

Yes, your inclination is right, the second interpretation is "correct". By correct, I mean that the general concept of risking a small amount on each trade (say 1/2 to 2%) and taking a larger risk on the total portfolio, is a common proven technique.

Ed Seykota coined the term "portfolio heat" to describe what you are calling total risk. I like that term because it is descriptive -- as the total percentage risk increases we feel more and more on the hot seat.

Both individual betsize and total betsize need to be considered. There are mathematical limits to consider, and just as importantly, personal psychological limits.

On the mathematical side, a methodology with a high win/loss rate may suffer smaller drawdowns and may benefit from a higher total risk. On the psychological side, a risk that may be acceptable to one trader may be unacceptable to another.

Here is a link to an article by Seykota (and Dave Druz) that briefly discusses the topic:

http://www.galtcapital.com/galt-pub.html

Regarding your question: "Is 5% or 10% total outstanding risk in a diversified account a totally risky amount". Well, not necessarily at all. It depends on mathematical attributes of your method, like win/loss ratio and avg. win to avg. loss, how truly diversified your bets are, whether you are running multiple methodologies, appetite for risk, acceptable drawdown, how long you are holding the positions -- stuff like that.

-- Alchemist

 
Thank you for such prompt and descriptive replies. I should have trusted myself a little bit more. I've actually read Mr. Seykota's paper at Galt before and I do like his description of "heat". This is a very interesting topic to me. I've done a lot of investigating lately between leverage useage and stop percentages. It's interesting to see how the two correlate and the limits of leverage use become very apparent very quickly. Basically if you are trading lets say a currency at 50 times leverage in a trend following system you may very well need a 25% stop loss just to get past the daily volatility. I don't think some people get this and they will set their stops at the lowest levels (1 to 2%) regardless of what amount of leverage they are using or what the market may be doing. They don't think systematically. Also I think when discussing these matters it would also be helpful to think of the role of diversification and probability. The probability of all trades coming up losers in a system that trades only 5 markets is exponentially larger than those odds in a system that trades 10 markets. I'm sure this has its limits but it is something to consider. Thanks again and I invite anyone else to please share their insights into money management or any other findings they've had.
 
other things you have to be aware of:

1]trading correlated markets or securities
2]the corollory being that you need to consider the possibility that all or most of your stops are triggered.

how much damage would that do to the portfolio? what if (due to execution or technical reasons) you take a higher R stop loss?

btw, most professional money managers set their R% much less than 2% (around 0.5%) can´t back this up with hard proof though!

also you can reduce your R to compensate for adverse trading conditions (such as post Sept 11th, personal reasons, string of losses, etc.) or increase it as the market trends, your confidence and P/L grows positive, etc.

 
Just last week I picked up 100 shares of RSTN at 8, one or two days later they warned and opened 50% down the next morning. Now this was to be a "longer-term" trade, with my assumption being that the Sept 21 low had held. OOPs.

Most months I sell puts to generate income. In September my losses were much greater than those listed above.

I owned some INTC when they warned, way back when.

Finally, I have had my computer freeze and even lost my DSL connection for 3 days this year.

Now none of these things may happen to you, but you need realize that this crap will come up, and it is not as simple as drawing a 1 or 2% line in the sand.

Hope that helped, or at least cheered you up.
 
Keep your positions small enough that if a trade goes to heck you don't loose more than 1%-2% of your account. "To heck" could mean a 4% shorting frenzy on a daytrade or a 25% gapdown on a swingtrade. Loosing 20% of your trading capital on a single bad trade is difficult to recover from financially and psychologically. 2% hurts but is relatively easy to overcome.
 
Thanks guys. I do realize the importance of missed stops and have coded my systems to reflect what actual prices I would actually be able to obtain on my way out. As you guys note there is sometimes not too huge a difference in performance between some percentage stops because of these unforseen anomolies that can take you out. As we all know the best laid plans of mice and men ...
 
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