I Will Not Go Bankrupt Tomorrow

I cannot guarantee you many things. But I can guarantee you that I will not go bankrupt tomorrow.

I might lose money. All my trades might get stopped out. All my new trades might go against me immediately. But I will not lose so much that I am forced out of business.

How do I know this? Because staying in business is the number one job of a trader.

As a trader there are some things that you can control, and some that you cannot. You cannot control what the market will do. But you can choose the terms on which you engage the market.

You can choose

  • Which markets to trade (market selection).
  • When to enter and exit (trade selection).
  • How much to buy or sell (position size).
  • How much of your portfolio to risk at any time (portfolio heat).

Of all these, market and trade selection gets the most attention in the financial press and blogosphere. Position size gets mentioned occasionally, but nowhere near enough given its importance: far too many traders trade the same number of share, contracts or dollars per trade regardless of the underlying market conditions. And portfolio heat gets the least attention of all.

Ed Seykota talks about bet size and portfolio heat as being far more important than trade selection, or fiddling with whether to use a 20 day or 22 day moving average, or whether a 15 p/e is cheap or expensive.

Think of every trade as a bet. If you bet small every time, you are unlikely to win very much. If you bet large, you are dramatically increasing your risk of ruin i.e. the chance that an unlucky streak will take you out the game. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin.

Portfolio heat refers to the number of open positions at any one time, and the amount of open risk in those positions. Risking 10% of your portfolio on one trade is very risky. Risking 5% on two (uncorrelated) positions is less risky. Risking 1% on each of 10 different trades is much safer. Risking 1% on 5 different trades is safer still.

Portfolio heat also considers the amount of open profit in a position. Imagine buying a stock at $100, with a stop of $95, and the stock rises to $110. If you keep your stop at $95, then the $10 gain is still at risk: it could disappear tomorrow. If you use trailing stops and raise your stop to break even or $105, you can reduce the amount of your portfolio at risk. Raising stops in the direction of winning trades allows you to reduce portfolio heat while still allowing winners to run.

I control my trading risk at several different levels. I have a maximum amount of my portfolio at risk on any trade. I also have a maximum number of positions open at any one time: even if my system gives me 50 phenomenal trade entry signals, I will not take them all, since that would put too much of my portfolio at risk.

I have no idea how much I could win tomorrow, but I know exactly how much I could lose. I am not going bankrupt tomorrow, and that helps me sleep.

Leave a comment

8 Comments

  1. An absolutely quality post again with two high quality links shared. I haven’t seen the first before so many thanks for sharing that. I also will not go bankrupt tomorrow as staying in business is indeed the number one job of a trader.

    Reply
    • Thanks Richard. Agreed, those links are pretty special, I’ve been saving them up! I’ve been doing a lot of thinking about the implications of portfolio heat recently; it can have a far bigger impact on the trading experience than trade selection.

      Reply
  2. yogi

     /  October 24, 2012

    this post brings to light issues I have in regards to someone saying they “never” take a trade unless its got 4:1 reward to risk ratio or 2:1 for that matter, and they say it with so much conviction. I’ve always wondered how a trade is managed when taken under this context, especially when price drifts back and forth ,not hitting the stop yet not hitting the assumed reward target, and eventually he sells and ends up with a 1:1 outcome, or price just about to hit his target but shy of a few points, does he sell, and when it pulls back to breakeven does he sell then?. How about, widen the time frame and set the reward at 10, that would mean take every trade? I’m sure the professional market timers will have rebuttals to this, and I’ve heard, read many.

    I think you have cleared this up for me when you elegantly say,

    “I have no idea how much I could win tomorrow, but I know exactly how much I could lose. I am not going bankrupt tomorrow, and that helps me sleep”,…this makes sense to me.

    Cheers

    Reply
    • Glad I could help.

      I have never understood the e.g. “4-1 risk/reward” type discussion, since it ignores the other key leg: the odds of each outcome. Any hero can buy a stock at $20, set a stop at $15 and a target at $40 and claim a 4:1 risk/reward ratio… That is incomplete nonsense: that is a great trade if the odds of $15 or $40 are 50/50, or a terrible one if the odds are 90/10. The key is expected value. And, of course, in real life you cannot know the odds in advance, you can only guess at them. You cannot control how much you might win, or your odds of winning: that is part of what makes it so crucial to control how much you can lose.

      Reply
  3. Familiar with the “Kelly criterion”?

    Reply
  4. I worked for a real estate agent who, whenever I did a good job, or we had a big win, would declare “You may work here yet another day!” Having a time horizon for celebrating success of “tomorrow” stays with me.

    Reply
  1. by the way… | The Reformed Broker

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