There are two keys to being a successful trader. One is that you must have a consistent statistical edge with your strategy. This can be either technical, fundamental, or a combination of both. The second key is managing your risk. Even if you have mastered either one of these two areas (strategy or risk management), if you have not mastered BOTH together, you will fail. In this entry, I am going to focus on risk management. There are many successful trading strategies out there with an edge from “Dogs of the Dow,” to “CANSLIM,” to TradingMarkets “PowerRatings.” Pick the strategy that best fits your personality, and understand all of its’ intricacies until you have have mastered it. But mastering your strategy alone is not the most difficult part of being a successful trader; I find that managing risk is the most treacherous part of trading.

For the most part, there are two main ways to manage position risk. Either you manage your risk with position sizing or you employ a tool that will manage your risk such as stops or options (options do a better job of this but cost more). If you manage your own risk through the use of position sizing, you, on average, perform better than if you had employed a tool to manage your risk (which inevitably costs you money per trade). You get paid for managing your own risk. I explain this in more detail in my prior entry "I Don't Use Stops, Here's Why..." But, in some cases, even though there is a “cost” in using stops or buying insurance in the options market, some people can perform better with this because they can safely increase their leverage.  Using stops or options may make less money on average than if the trader had used position sizing for risk control-but their overall account may perform better because of the increased leverage that can be safely used as a result of using either the stops or options. (Let me know if this seems tricky).

Another facet of risk management, which I believe is critical, is your “risk of ruin”, or as some traders call it your chance of “blowing up.” I wish I could tell you that there is some simple formula that would tell me or you what to do regarding this, but there is not. The risk of ruin, is your chance of losing everything because of a string of losses or a collection of losses occurring simultaneously despite your strategy’s statistical edge. Casinos are keenly aware of this and make sure that the chance of this happening to them is amazingly small. For example, you can not go to a blackjack table and bet 5 billion dollars. The risk of ruin for the casino  with this is way too high despite the fact that the casino has an extremely profitable blackjack strategy. There is a significant chance that the casino will lose everything despite the fact that the odds are in their favor. In order to control this-there are limits at the tables (they are also there because of the Martingale betting strategy-google it if you're interested). Let me put it another way so it makes more sense in terms of trading. Let’s say someone offers to play a game with you where you put up a dollar and you flip a coin-if the coin turns up heads you win $2 (so you get $3 back), and if it is tails, you lose your dollar. Nice game, huh? You have an incredible edge. In 10 coin flips-you should win 50% of the time, so after 10 flips you should lose $5, and win $15. This is great! With these kind of odds, most people would say-how much can I put down per flip? Can I risk $10 per coin flip, $50, how about $100,000? Well, the answer to that question is all relative to how much total money you have. In the case of the $1/bet game-imagine if you only had a total of $1. Well, in this case there is a 50% chance that you will turn up broke on the first flip...So even if you have a statistical edge over time, like in this simple game, you must consider your total account value in determining your bet size.  For instance, you may consider only betting $0.10 per game so that the true odds of the game could work to your advantage, but even in that case there is a chance (1/1024) that you could lose all 10 games consecutively - and lose all your money - even though you have a strategy that has a strong long-term edge. Overall, your risk of ruin is the single biggest determinant of how big your position sizes should be.

Now, you may be thinking that you can safely determine your position size by backtesting your system and looking at the biggest historical drawdown (percentage move from high to low).  For instance, if you find that in the last 20 years that the biggest drawdown has been 25%, you may think that you can safely trade with 200% (You would lose only 50% of your account-2 x 25%). Scientifically it makes sense. But, in reality, it is not true. This is where chaos comes into play. Here is the definition from wikipedia.com

“...in mathematics and physics, chaos theory describes the behavior of certain nonlinear dynamical systems that under certain conditions exhibit dynamics that are sensitive to initial conditions (popularly referred to as the butterfly effect). As a result of this sensitivity, the behavior of chaotic systems appears to be random, because of an exponential growth of errors in the initial conditions. This happens even though these systems are deterministic in the sense that their future dynamics are well defined by their initial conditions, and there are no random elements involved. This behavior is known as deterministic chaos, or simply chaos.”

The stock market is a nonlinear dynamical system.  In essence, what this theory says is that the market is unpredictable. In most “normal” circumstances there is some predictability-this is why many stock market systems work the majority of the time. But every once in a while chaos will ensue, and in those times everything that you have studied will be irrelevant. Highly improbable events will occur more often than you or statistics will have predicted-and the only thing that will save you from ruin is your risk management. In other words, the only surefire way to protect your account from ruin is to have less than 100% at risk at any given time.

Overall, the purpose of this article is not to tell you how to manage your risk, that is an individual choice. Perhaps when your account is small relative to your income, you may want a more risk (bigger position sizing) because you can just work to replenish your account, and you want to quickly increase your account size to several times your monthly income. Then, later on, as your account grows, you may want to decrease your position sizing (risk) because the amount of money in your account is not an amount that you can easily get back just by working. It is an individual choice just as choosing the strategy that you are trading is. But, the only way to truly be able to assess and manage your risk of ruin is to understand that it exists, how it works, and the effect that chaos plays on it.

I hope this helps

Steve