Time Crunch Trading

The idea of risk or money management for the trader is inherently a negative one. This can be a very unusual situation for those who are used to thinking in positive terms. Nevertheless, it is important to approach your trading in the proper manner.

It is very easy to get caught up in fantasizing about big profits, but the successful trader spends their time focusing on the odds of losing and how much. Why? Because there will always be opportunities to make trading profits, but only if one remains in the game. The trader who takes on too much risk increases the odds that he or she will be knocked out of the game, which is why we employ money management strategies.

Earlier in this chapter we talked about determining your own risk profile and defining it. Now is the time to put that into an action plan to guide your trading. This final section of the chapter presents a series of questions that should be addressed.

How much of a loss in account value are you willing to accept before halting your trading?

Decide where your “uncle” point is—the loss at which you shut everything down and stop trading. Hopefully, this never actually occurs, but if it does you should have a contingency. That is part of the planning process.

The ideal viewpoint here is to pick a point, where if you go beyond it, you have to draw the conclusion that there is either a problem with your trading execution or with your trading system. Either way, it is good to stop and assess things, which is what this kind of circuit-breaker does.

The decision as to where to put this point combines elements of your personal comfort and expectations for the performance of your trading system.

What kind of drawdown are you willing to accept?

This speaks to the earlier discussions of personal risk tolerance. It also brings in the “loss to break-even” analysis mentioned at the start of this chapter. In short, it is the degree to which you are willing to accept fluctuations in your portfolio’s value.

Are you the slow and steady type, or do you not mind riding the roller coaster?

Your decision here will influence the types of trading systems in which you are likely to trade as well as the per trade and overall risk you are willing to take.

How much risk, as a percentage of your portfolio, will you take on a per trade basis?

Some of the best traders of all time limit their per trade risk to no more than 1-2% of their total portfolio worth. This may seem like a very small value, but it must be considered in terms of frequency of trade. Someone who is a day or swing trader, or who operates in a similarly short timeframe will have more trades over a given time span than will a longer-term trader. That being the case, they have a higher probability of experiencing a significant run of negative performance than would the less frequent trader.

Here is where we put you through some statistical stuff. Don’t get too worried. It’s not that complicated. We touched on this concept earlier in the chapter.

Assume that we have a trading system with a likelihood of losing on any given which can be expressed as p. For a coin toss kind of system p would be 50%, or 0.5.

With p we can then determine the probability of some number of consecutive losing trades taking place. Call that number x. If we want to consider a five trade losing string, x would be equal to 5.

To get the likelihood of x consecutive losing trades, with p as the probability losing on a given trade, we must calculate the value of p to xth power. or px. Thus, if we have a 50% loss percentage and are considering a run of five consecutive trades, the probability of that occurring is .5x.5x.5x.5x.5=0.03125 (assuming the per trade probabilities are independent, meaning the result of one trade has no impact on the chances of the next trade winning or losing). That is a little more than 3%, which sounds pretty small.

This figure is a bit misleading, though. While it is true that it is unlikely to get five consecutive losses given the probabilities, that is only applicable when all you look at is five trades.

As you go beyond five observations, the odds of having a run of 5 consecutive losses increases, to the point of reaching 100% when the number of trades gets large enough. For example, a day trader making 1 trade per day (about 260 each year) would be almost certain of having at least one run of five losing trades in a row.

As noted, you can run scenarios looking at the probability of an x-loss run given a trade total and success rate with the calculator available at: www.anduriloneline.com/book/calculator.aspx

Having this sort of information at-hand is extremely useful when making risk management decisions. It probably is not a good idea to risk 10% of your account per trade when you have a 75% likelihood of seeing at least one run of five or more consecutive losing trades. That’s a fast way to blow up your account.

We have not yet begun working through developing a trading system or method, but you can still make some approximations based on the timeframe you are planning on using. We will revisit this topic later in the text.

How much of your account or portfolio will you have at risk in total at any given time?

If you only plan on trading one position at a time, then the answer is the same as the one in the previous question.

If, however, you plan on having multiple trades open, you need to define what kind of net exposure you will take. You can still use the estimations we discussed above as a guide to where your risk level should be, but you will probably have to make an adjustment.

Instead of thinking in terms of trades, as we were previously, you must think in terms of timeframes. The timeframe in question would be based on the combined holding period of the positions in question. For example, a swing trader who has a 1-3 day holding period on any given trade might think in terms of 2-3 day periods. In that manner, he/she could perform the same kind of loss-run assessment as done above, but with a different perspective.

This is where the correlation discussion we had in the last section comes back in to play. Trading highly correlated positions will create a higher portfolio risk than would be implied by just looking at the each portfolio holding individually. Uncorrelated positions (remember we’re talking on a forward looking basis) will generally decrease that overall risk. It is this unified approach which is your most optimal measure for determining where you should make your portfolio risk cut-off.

Risk Management Plan Application

A plan not applied is a worthless plan. While working through your risk and money management strategy, take the decisions you are making and the way you will apply them seriously. Keep things as simple as possible.

The stress of trading, which can be experienced regardless of whether you are winning or losing, can wreak havoc on your risk management strategy. In fact, that is the portion of your overall trading plan most likely to go out the window.

Consider two very simple examples.

Joe has just made a very nice gain. Sue, on the other hand, just experienced a significant loss. Both may feel compelled to trade bigger on their next position. Joe is feeling good. The adrenaline is pumping. “Why not trade bigger? The system is doing well. Let me see if I can improve my returns.”

Sue, on the other hand, might think about making that loss back. “It’s a good system, after all. Why not trade a little bigger this time and make up for the loss?” Notice that neither is thinking about deviating from the trading system at this point, just the risk management strategy. They have both stopped thinking about the potential for loss on the next trade.

The important thing to take away from this chapter is that you must either think of risk on the front end of the trade or face the prospect of realizing the riskiness of market participation at some future point. It can be compared to car upkeep and maintenance. You can either do the little things to keep your car in good shape (oil changes, regular service, etc.), or you can wait for a major problem to crop up which will cost far more in time or money than had you just done what you should have done along the way.

At this stage we have sufficiently begun to address the requirements for risk and money management in our trading. Do not think we are done with the topic, though. It will come back in to play later.