Time Crunch Trading

We mentioned the topic of risk tolerance earlier. Before you can properly outline a meaningful risk or money management strategy you first have to understand and define your personal risk tolerance. Some people are naturally risk-averse. They will tend to only feel comfortable exposing small amounts of their portfolio to the potential for loss. Others are more risk-tolerant and can stomach wilder portfolio swings.

Much goes in to the tolerance determination – age, income, life situation, personality – but the central point is that your risk management strategy must take everything into consideration. Risk tolerance goes a long way toward determining the manner in which you can operate. Once it is understood, the other elements discussed in this chapter will fall in to place.

You need a way to define your risk tolerance so that you can use it later on as you develop your money management scheme. The best way to do so is in terms of a percentage of your portfolio.

Think two ways. The first is in terms of a single trade. How much of your portfolio can you lose on a single trade before starting to get squeamish. The second angle in defining risk tolerance is in terms of what is generally referred to as portfolio drawdowns. A drawdown is the distance (measured in % or account/portfolio value terms) from an equity peak to the lowest point immediately following it.

For example, say your portfolio rose from $10,000 to $15,000, fell to $12,000, then rose to $20,000. The drop from the $15,000 peak to the $12,000 trough would be considered a drawdown, in this case of $3000 or 20%.

You must determine – in percentage terms - how large a drawdown you are willing to accept. It is very much a risk/reward decision. 

On one extreme are trading systems with very, very small drawdowns, but also with low returns (low risk – low reward), making for a smooth equity curve (the plot of your portfolio value over time). On the other extreme are the trading systems with large returns, but similarly large drawdowns (high risk – high reward). They have more jagged equity curves.

Of course, every trader’s dream is a trading system or method with high returns and small drawdowns. Unfortunately, reality is often somewhere in between.

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