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Educational Article

More On Managing Risk

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Last week we talked about the basics of managing risk, beginning with the proper use of Stop Loss orders (through reference to a prior article) and then extended the discussion to looking at how intelligent selection of entry points can help us to mitigate our risk in a trade. Specifically, buying/selling near important support/resistance levels allows us to set stops just the other side of those support/resistance levels. Then I extended the train of thought to selecting the right options trade, based on selecting stocks/options with the appropriate liquidity for each individual's risk tolerance.

Apparently that got a lot of readers' brains whirling, as I got a fair amount of questions asking for more information on how to properly manage risk, both on an individual trade basis, as well as for an overall account. Being an engineer in my prior life, I'm always reluctant to reinvent the wheel if it isn't necessary. One of my early engineering mentors pointed out to me that engineers are basically lazy, and it is our desire to find more efficient solutions to problems and rely on the discoveries of others in order to accomplish more with less effort. When it comes right down to it, that's what engineers do, take advantage of prior discoveries, so that they can leverage that knowledge into new and better cars, airplanes, TVs, computers, etc.

Keeping with that theme, I'm going to start out by echoing the recent words of our own Jeff Bailey. In yesterday's Market Monitor, Jeff pointed out how to evaluate position size, relative to the overall account. I think the key point that Jeff makes is that before we ever implement the first trade in an account, we MUST have a detailed, written business plan that dictates every aspect of how we are going to trade that account. It needs to include our goals and expectations (such as percentage return), as well as how we intend to trade that account and how we will manage risk. In my experience, failure to go through this process is at the core of just about every blown-up account. This observation led me to write What To Do When You Can't Do Anything Right back in April. If you missed that article back when I first wrote it and you don't have that detailed trading plan sitting on your desk right now, then you need to read it.

We need to understand that the roadmap that I laid out in that article is just the starting point, as it is then incumbent on the individual to do the hard work of answering all the questions laid out in the numbered list in the lower half of the article.

One of the things that requires a lot more clarification than what I provide in that article is what type of money management system to employ. This part of the trading plan needs to address questions such as What is the maximum amount I can risk in any given trade? Also important are the issues of the maximum portion of the account that should be exposed to risk at any given time (i.e. what is the minimum amount of cash to always hold). Defining the amount of risk you are willing to accept in any specific trade then leads to other questions such as: If trading options, will I use stop losses or limit my position size such that I can use 100% risk capital on each trade?

If you've already answered all of these questions for yourself, then you're well on your way (or perhaps already there) to having a strong, usable trading plan. But for everyone else, you've got some work to do. Fortunately we have some more great educational content available in the Trader's Corner archives. For fairly new subscribers, let me encourage you to go through these archives -- there is a wealth of information contained therein, equal to a graduate degree in trading methodology and experience.

Coming back to our Risk Management theme, I owe 'Gumby' (long-time OI reader) a huge debt of gratitude to pointing out a great series of articles written on the topic of Account Management back in the ancient past of late 2000 and early 2001. If you're still struggling for a way to quantify your risk management rules, I would highly recommend perusing the following articles.

Methodical Account Management
Methodical Account Management II
Proper Account Management (Through Good Times & Bad)

Gumby went on in his email to describe a purely mechanical approach he uses for Risk Management, that dovetails nicely with both Austin's descriptions in the above articles, as well as Jeff's use of the terms like 'Full Position' or 'Half Position'. Rather than try to reword his description, I'll just let you read it here as I received it.

"After reading these articles, I generated a simple spreadsheet; account size in one cell (A1), pre-calculated % risk (B1=0.05*A1), position cost (C1), pain level (D1 - can be your estimated cost if price action hits a certain point, or you could set your stop at a % level - depends upon your strategy), then calculated # of contracts [risk/((cost-stop)*100)], to give you the size of a full position. OK, for the techies, it's: B1/((C1-D1)*100 per contract). One can then judge the scenario, see if a full, half or quarter position is warranted; easy to do when one knows what a "full" position is at any given time in a cycle. Also, after setting up the spreadsheet, all you do is the planning part - enter the current cost, your maximum pain level on the position, and viola! I find it quite useful at various times, in that I like to play front-month contracts - in the first week of a cycle, I'll either fix the loss to a given % or to a previous contract price given price action at a known support/resistance level. Or, in the last few days of a cycle, set the stop loss at zero - doesn't matter much, in that my maximum account risk is known and fixed prior to entering the trade. If traders can incorporate this or some similar method into their trading practice, it forces you to do several critical, related topics, including selection of exit point (prior to entry) and implementing a strategy of risk management. And all you have to do is plug in a couple of numbers."

All I have to add to that is THANKS! What Gumby has done here is create a mechanical system that he can plug a prospective trade into and it tells him exactly how large a position to put on, based on his tolerance for risk -- which he defines. As a side note, I think I can say with a high degree of certainty, that he has his detailed trading plan already written and sitting within easy reach of his trading station. I think that is a good signal to all of us of the importance of taking the time to develop our own trading plan.

I know this approach will appeal to all the other "lazy" engineers out there, and hopefully even those that aren't overly fluent in Excel can use this information to their benefit. It's kind of like the tagline on the commercial frequently seen on CNBC - "Manage your risk and you can do anything." How true!

Questions are always welcome.


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