The Unmentioned Risk of Trading Too Small

[Stockie]

You hear it over and over: never risk more than 1 percent of your account on any trade.

Others say 2% or 5% and I've heard of some risking no more than 0.5%.

But I've been aware lately of the risk I face of trading too small.

If I went my trading career only ever risking 0.5% and executed 100 trades per year, assuming a risk:reward of 1:2 and win rate of 0.5 I'd grow my account by 25% annually. If on the other hand I risked 2% using the same strategy I'd grow my account by about 250%.

Over 5 years, assuming I efficiently compounded, at 0.5% risk I'd have a return of 300%. But at 2% risk the return would be more like 10,000%.

By trading too small I'd risk missing out on a significant amount of profit.

According the maths (British spelling) over that 5 year run I'd be likely to experience a losing streak of 9 losses in a row. At 0.5% risk that would be a 4.5% drawdown and at 2% risk an 18% drawdown. The 18% drawdown wouldn't be fun but it wouldn't matter in the long run, the return is still 10,000%.

(By the way, I'm cooking and knocked up those numbers quickly - so may not be correct!)

This is all theoretical and in reality efficiently compounding isn't necessarily practical, but my example demonstrates that we should aim to risk the optimal amount according to our strategies and long term account accumulation.

Is my thinking on this wrong?

 

[slumdog]

How many losers in a row is not the same as your worst case drawdown.


Your worst drawdown is probably double the longest expected losing streak.

eg, 9 losers, 1 small winner, 4 more losers, 2 small winners, 4 more losers etc

Then you have to factor in changing market conditions: forward trading losing streaks are likely to be worse than expected, as markets change and your edge begins to deteriorate.


We talking 33%+ worst case drawdowns when risking 2% of the account on any trade. More likely 40% drawdowns.

Your best hope is to get lucky and make 10,000% with just 20% drawdowns, before you get hit with the inevitable 40% drawdown.

 

[jack hershey]

Quote from Stockie:

You hear it over and over: never risk more than 1 percent of your account on any trade.

Others say 2% or 5% and I've heard of some risking no more than 0.5%.

But I've been aware lately of the risk I face of trading too small.

If I went my trading career only ever risking 0.5% and executed 100 trades per year, assuming a risk:reward of 1:2 and win rate of 0.5 I'd grow my account by 25% annually. If on the other hand I risked 2% using the same strategy I'd grow my account by about 250%.

Over 5 years, assuming I efficiently compounded, at 0.5% risk I'd have a return of 300%. But at 2% risk the return would be more like 10,000%.

By trading too small I'd risk missing out on a significant amount of profit.

According the maths (British spelling) over that 5 year run I'd be likely to experience a losing streak of 9 losses in a row. At 0.5% risk that would be a 4.5% drawdown and at 2% risk an 18% drawdown. The 18% drawdown wouldn't be fun but it wouldn't matter in the long run, the return is still 10,000%.

(By the way, I'm cooking and knocked up those numbers quickly - so may not be correct!)

This is all theoretical and in reality efficiently compounding isn't necessarily practical, but my example demonstrates that we should aim to risk the optimal amount according to our strategies and long term account accumulation.

Is my thinking on this wrong?

Yes.

 

[Stockie]

Slumdog, thanks for pointing that out.

Jack, thank you for your concise answer. Can you elaborate?

 

[iankotze]

a Safer way to approach it would be to keep your risk as small as possible and even go smaller on it as your account grows.

So for instance if you start out with 2% risk your aim should be to bank enough money to get to 1% risk without changing size, from there you could even go for a 0.5% risk before changing size. This way you get yourself in a situation where your risk of ruin gets reduced way down so you can have your focus on your trading and not on the money and fear of blowing up when the draw down comes.

The way it works in the end is that the account balance if growing will afford you to up size without adding more risk percentage wise and upping your risk of ruin. When you start to go through tough times you can then just adjust your size down to stay inline with your risk parameters.

The goal of trading is to make money yes, but sustainability and growth of the account can only be achieved by watching and managing your risk and downside so you can stay in the game to cash in on those few times when everything just falls into place.

One of your main goals then becomes to protect those profits by reducing your risk even further percentage wise as the account grows while still upping size when the account allows it to be done and reducing size when you have to go into survival mode for some periods of time.

 

[Stockie]

Quote from iankotze:

a Safer way to approach it would be to keep your risk as small as possible and even go smaller on it as your account grows.

So for instance if you start out with 2% risk your aim should be to bank enough money to get to 1% risk without changing size, from there you could even go for a 0.5% risk before changing size. This way you get yourself in a situation where your risk of ruin gets reduced way down so you can have your focus on your trading and not on the money and fear of blowing up when the draw down comes.

The way it works in the end is that the account balance if growing will afford you to up size without adding more risk percentage wise and upping your risk of ruin. When you start to go through tough times you can then just adjust your size down to stay inline with your risk parameters.

The goal of trading is to make money yes, but sustainability and growth of the account can only be achieved by watching and managing your risk and downside so you can stay in the game to cash in on those few times when everything just falls into place.

One of your main goals then becomes to protect those profits by reducing your risk even further percentage wise as the account grows while still upping size when the account allows it to be done and reducing size when you have to go into survival mode for some periods of time.

I'm only just out of the gates into trading real money and still trading nominal amounts. I agree that reducing risk in the long run as an account grows is sensible and I'll certainly be thinking that way in the future.

 

[Stockie]

I had thought money management was the easy M of the three M's (Mindset, Method, Money Management). Relatively I think it probably is, but there are some nuances which make it a somewhat fuzzy area.

I have considered varying position size (risk) depending on market conditions or/and recent performance (daily/weekly/month P&L/drawdown), but came to the conclusion that if a trade's worth taking it should be taken with full size. Varying position size to me is like adding a secondary degree to my trading, which could be counter productive.

I'm starting to think sticking with a bog standard rule of thumb like "1%", at least in the short term, might not be such a bad idea.

I'm not looking for an absolute answer here, just perhaps some insight from those with a track record.

 

[actionzip54]

Stick with 1% until you really start to know your methodology.

I know many traders who can risk 5% because they have very high win rate methodologies and their number of losers in a row are relatively small. Many of them cut size quickly after say 2 losers in a row and again at 4. I would strongly advise a beginner to just keep his risk the same until he has survived a tough drawdown or two. A 20% or 30% whack sounds easy until you've had it happen. Also, always expect your largest drawdown to be larger than whatever you think it could be.

 

[iankotze]

Yes all true, it is a bit complicated and it all depends on what you trade, how you trade and so on. What I was saying before is keep your trades the same size before moving to the next level only once your account justifies such a move.

I personally don't work with % but rather dollar amount. So once I reach a new level in the account I start going up in size, once the account balance falls below that set amount I reduce size again.

Placing these block zones in the equity is useful to me so I can have empirical evidence that I need to size down when things go badly as not to get wrapped up in it all and double down as I see many traders do and then blow up in the end.

Think of it like this, if you reach the next level you reward yourself with the opportunity to up size a bit and therefor stand a change of gaining more income. When you go through a bad patch and your account goes down one level you know you must switch to defensive position and reduce size and focus on trading small and wait until the market and yourself connects again which usually results in you starting to make money again and then maybe even getting to the next level where you can reward yourself.

The whole thing takes a lot of time but hey if you are in this for the long haul then time is something you have because if you do the right things today you will be able to come back tomorrow and the next day until you chose not to come back rather than having the market force you to leave broke and disappointed.

 

[jack hershey]

Quote from Stockie:

Slumdog, thanks for pointing that out.

Jack, thank you for your concise answer. Can you elaborate?

For your orientation (3M's), I would say right off that you will have to take on too many stocks in your portfolio.

At 5%, you would have 20 different stocks to deal with.

My limit is 12 and I have that because of the complexity of optimizing my positions.

Originallly I put 25% into each of four stocks and learned to manage them optimally.

Once I passed the knee of the learnng curve my focus became effectiveness and efficiency.

In compounding capital, I ranked the three variables so that my turnover of positions would be maximized without giving up a percent of profits per profit segment.

I entered late and exited early. This portion of a profit segment has the highest money making velocity. By entering late I eliminated the possibility that an entry would not work. Exiting early was simple because I HAD to exit since a new unheld stock was making a greater money making velocity.

I limited my holdings per stock to 100,000 shares since entering and exiting a position must be done with partial fills no larger than the T&S blocks passing through.


All stock trading has limitations. I am extremely risk adverse so I do not deal with risk. To assure no risk, I filter 15,000 stocks down to about 100+. My filter has seven expressions. Two are adjustable so the the list is fixed as to length. When I filter I also create an order of trading by the independent variable. Ranking is also done but only for choosing among available stocks at a given time.

A coached beginner who uses 27K can earn at the rate of 150K annualized by the end of the first quarter using 4 stocks. In another month his annualized earnings become 250K

My views are limited to my experience and the experiences of others I have worked with.

Most people who trade do not concern themselves with what is important. Making money, apparently, is not well understood.

I started with 300 dollars in 1957.

My best 100,000 share trade netted 17 points a share; I only left 200K on the table.