Risk Management

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Risk Management

A good trading system delivers greater profits than losses over a period of time, but even the most carefully designed system doesn’t guarantee success in every trade. No system can assure you of never having a losing trade or even a series of losing trades.

A system is a plan, but as Helmuth von Moltke, a nineteenth-century German field marshal, wrote: “No plan survives contact with the enemy.” The U.S. boxer Mike Tyson, quoted by The Economist, put it more bluntly: “Everyone has a plan ‘til they get punched in the mouth.” This is why risk control must be an essential part of every trading system.

The inability to manage losses is one of the worst pitfalls in trading. Beginners freeze like deer in the headlights when a deepening loss starts wiping out profits of many good trades. It’s a general human tendency to take profits quickly but wait for losing trades to come back to even. By the time the despairing amateur gives up hope and closes his trade with a terrible loss, his account is badly and sometimes irreparably damaged.

To be a successful trader, you need to learn risk management rules and firmly implement them.

■ 48. Emotions and Probabilities

Money stirs up powerful feelings. The emotional storms, raised by making or losing money, hit our trading.

A beginner rushing to place an order may feel giddy with the excitement. He will soon find out that the market offers a painfully expensive form of entertainment. Early in my career, I heard from a professional trader that “successful trading should be a little bit boring.” He spent long hours each day doing homework, sifting through market data, calculating risks, and maintaining records. Those time-consuming tasks weren’t exciting—but his success was built on such grunt work. Beginners and gamblers get a full load of entertainment, but pay for it with losses.

Another emotional mistake is counting money in open trades. Newbies dream about what they can buy with open profits or freeze from the shock of comparing open losses to their paychecks. Thinking about money interferes with decision making. Professionals focus on managing trades; they count money only after those trades are closed.

A trader who counts profits in an open trade is like a lawyer who, in the middle of a trial, starts dreaming of what he’ll buy with his fee. That trial is still going on, his opponents are building a case against his client, and counting money will not help him win—quite the contrary, it’ll distract him and cause him to lose. An amateur who becomes upset counting losses in an open trade is like a surgeon who throws a tray of instruments after the patient on the table starts bleeding—his frustration will not improve the outcome of the case.

Professional traders don’t count money in open trades. They do it at the end of an accounting period, such as a month.

If you were to ask me about an open trade, I could answer that it’s a bit ahead, a lot ahead, or a bit behind (a lot behind is unlikely because of my stops). If you were to press me for a number, I might tell you how many ticks I’m ahead or behind, but I’ll never translate those ticks into dollars. It took me years to train myself to break the destructive habit of counting money in open trades. I can count ticks, but my mind stops before converting them into dollars. It’s like being on a diet—there is plenty of food around, but you don’t touch it.

Focus on managing your trade, and the money will follow almost as an afterthought. Another key point: a professional doesn’t get worked up about his wins or losses in a single trade. There is a great deal of randomness in the markets. We can do everything right—and still end up with a losing trade, just like a surgeon can do everything right and still lose a patient. That’s why a trader should care only about having a method with a positive expectation and work on being profitable at the end of his accounting period.

The goal of a successful professional in any field is to reach his personal best—to become the best doctor, the best lawyer, or the best trader. Handle each trade like a surgical procedure—seriously, soberly, without sloppiness or shortcuts. Concentrate on trading right. When you work this way, money will come later.

Why Johnny Can’t Sell

Your survival and success depend on your willingness to cut losses while they’re relatively small.

When a trade starts going against a beginner, he hangs on, hoping for a reversal in his favor. When he gets a margin call, he scrambles to send more money to the broker, as if the initial loss hadn’t been bad enough. Why should a losing trade turn in his favor? There’s no logical reason, only wishful thinking.

Stubbornly holding a losing trade only deepens the wound. Losses have a way of snowballing until what initially seemed like a bad loss starts looking like a bargain because the current drawdown is so much worse. Finally, a desperate loser bites the bullet and closes out a trade, taking a severe loss.

Right after he exits, the market reverses and comes roaring back.

The trader is ready to smash his head against a wall—had he hung on, he would have made money. Such reversals happen time and again because most losers respond to the same stimuli. People have similar emotions, regardless of their nationality or education. A frightened trader with sweaty palms and a pounding heart feels and acts the same way, whether he grew up in New York or Hong Kong and whether he had 2 or 20 years of schooling.

The intellectual demands of trading are modest, but its emotional demands are immense. Many years ago, a highly educated but very emotional trader showed me how to trade divergences near channel walls. I fine-tuned his method, added risk management rules, and continue to make money with it to this day. The man who taught me had busted out because of his lack of discipline and ended up going door to door, selling aluminum siding. Emotional trading and impulsivity are not good for success.

Roy Shapiro, a New York psychologist from whose article the title of this subchapter is borrowed, writes: “With great hope, in the private place where we make our trading decisions, our current idea is made ready… one difficulty in selling is the attachment experienced toward the position. After all, once something is ours, we naturally tend to become attached to it… This attachment to the things we buy has been called the “endowment effect” by psychologists and economists and we all recognize it in our financial transactions as well as in our inability to part with that old sports jacket hanging in the closet. The speculator is the parent of the idea… the position takes on meaning as a personal extension of self, almost as one’s child might… Another reason that Johnny does not sell, even when the position may be losing ground, is because he wants to dream… For many, at the moment of purchase, critical judgment weakens and hope ascends to govern the decision process.”

Dreaming in the markets is a luxury we can’t afford.

Dr. Shapiro describes a test that shows how people conduct business involving a chance. First, a group of people are given a choice: a 75 percent chance to win $1000 with a 25 percent chance of getting nothing—or a sure $700. Four out of five subjects take the second choice, even after it is explained to them that the first choice leads to a $750 gain over time. The majority makes the emotional decision and settles for a smaller gain.

Another test is given: People have to choose between a sure loss of $700 or a 75 percent chance of losing $1000 and a 25 percent chance of losing nothing. Three out of four take the second choice, condemning themselves to lose $50 more than they have to. In trying to avoid risk, they maximize losses!

200 RISK MANAGEMENT

Emotional traders crave certain gains and turn down profitable wagers that involve uncertainty. They go into risky gambles to postpone taking losses. It is human nature to take profits quickly and losses slowly. The irrational behavior increases when people feel under pressure. According to Dr. Shapiro, at the racetrack, “bets on long shots increase in the last two races of the day.”

Prof. Daniel Kahneman writes in his book Thinking, Fast and Slow: “The sure loss is very aversive, and this drives you to take the risk … Considerable loss aversion exists even when the amount at risk is minuscule relative to your wealth … losses loom larger than corresponding gains.” He adds: “Animals, including people, fight harder to prevent losses than to achieve gains” and spells it out: “People who face very bad options take desperate gambles, accepting a high probability of making things worse in exchange for a small hope of avoiding a large loss. Risk taking of this kind often turns manageable failures into disasters.” Why do we act this way? Prof. Kahneman explains: “Except for the very poor, for whom income coincides with survival, the main motivators of money-seeking are not necessarily economic. Money is a proxy for points on a scale of self-regard and achievement.” These rewards and punishments, promises and threats, are all in our heads.

Emotional trading destroys losers. A review of trading records usually shows that the worst damage was done by a few large losses or a long string of losses, while trying to trade one’s way out of a hole. The discipline of good money management would have kept us out of that hole in the first place.

Probability and Innumeracy

Innumeracy—the inability to count or understand the basic notions of probability is a fatal weakness for traders. The counting skills aren’t hard, can be picked up from many basic books, and then sharpened with some practice.

The lively book Innumeracy by John Allen Paulos is an excellent primer on the concepts of probability. Paulos describes being told by a seemingly intelligent person at a cocktail party: “If the chance of rain is 50 percent on Saturday and 50 percent on Sunday, then it is 100 percent certain it will be a rainy weekend.” Someone who understands so little about probability is sure to lose money trading. You owe it to yourself to develop a grasp of the basic mathematical and logical concepts involved in trading.

There are very few ironclad certainties in market analysis, which is largely based on probabilities. “If the signals A and B are present, then the outcome C will occur” is not the kind of logic that holds up in the markets.

Ralph Vince begins his important book Portfolio Management Formulas with this delightful paragraph: “Toss a coin in the air. For an instant you experience one of the most fascinating paradoxes of nature—the random process. While the coin is in the air there is no way to tell for certain whether it will land heads or tails. Yet over many tosses, the outcome can be reasonably predicted.”

Mathematical expectation is an important concept for traders. Each trade has either a positive expectation, also called the player’s edge, or a negative expectation, also called the house advantage, depending on who has better odds in a game. If you and I flip a coin, neither of us has an edge—each has a 50 percent chance of winning. If you play the same game in a casino that takes five percent from every pot, you’ll win only 95 cents for every dollar you lose. This “house advantage” will create a negative mathematical expectation. No system for money management can beat a negative expectation over a period of time.

A Positive Expectation

A skilled card-counter has an edge against a casino, unless they detect him and throw him out. Casinos love drunken gamblers but hate card counters. An edge lets you win more often than lose over a period of time. Without an edge, you might as well give money to charity. In trading, the edge comes from systems that deliver greater profits than losses, after slippage and commissions, over a period of time. Acting on hunches leads to losses.

The best trading systems are simple and robust. They have very few elements. The more complex the systems, the higher the risk that some of its components will break.

Traders love to optimize systems, making them fit past data. The trouble is, your broker won’t let you trade in the past. Markets change, and indicator parameters that would have nailed the trends last month are unlikely to nail them a month from now. Instead of optimizing your system, try to de-optimize it. A robust system holds up well to market changes and beats a heavily optimized system in real trading.

Finally, once you develop a good system, stop messing with it. If you like to tinker, design another system. As Robert Prechter put it: “Most traders take a good system and destroy it by trying to make it into a perfect system.”

Once you have a trading system that works, it’s time to set the rules for money management. You can win only if you have a positive mathematical expectation from a sensible trading system. Money management will help you exploit a good system, but cannot rescue a bad one.

Businessman’s Risk or Loss

We analyze markets in order to identify trends. Be careful not to become overconfident when anticipating future prices. The future is fundamentally unknowable. When we buy, expecting a rally, it is entirely possible that an unforeseen event may flip the market and send it down. Your actions in response to surprises will define you as a trader.

A pro manages his trades, accepting what’s called a “businessman’s risk.” This means that the amount he risks exposes him to only a minor equity drop. A loss, on the other hand, may threaten an account’s health and even survival. We must draw a clear line between a businessman’s risk and a loss. That border is defined by the fraction of the account a trader puts at risk in a trade.

If you follow the risk management rules described below, you’ll accept only a normal businessman’s risk. Violating a well-defined red line will expose you to dangerous losses.

“This time is different,” says an undisciplined trader. “I’ll give this trade a little extra room.” The market seduces traders into breaking their rules. Will you follow yours?

Once, I chaired a panel at a gathering of money managers at which one of the presenters had nearly a billion dollars in his fund. A middle-aged man, he got into this business in his 20s, while working for a naval consulting firm after graduate school. Bored with his day job, he designed a trading system but couldn’t trade it because it required a minimum of $200,000, which he didn’t have in those days. “I had to go to other people,” he said, “and ask them for money. Once I explained to them what I was going to do and they gave me money, I had to stick to my system. It would have been unconscionable to deviate from the system I told them I would follow. My poverty worked for me.” Poverty and integrity.

■ 49. The Two Main Rules of Risk Control

If trading is a high-wire act, then safety demands stringing a net underneath that wire. If we slip, the net will save us from getting smashed against the floor. The only thing better than a safety net is two safety nets: if one doesn’t catch us as we fall, the other will.

Even the best planned trades can go awry because of randomness in the markets. Even the best analyses and the clearest trade setups can’t prevent accidents. What you can control is risk. You do it by managing the size of your trades and the placement of stops. This is how you keep the inevitable losses small, not allowing them to cripple your account, so that you can win in the long run.

Ugly losses stick out like sore thumbs from most account records. Every performance review shows that a single terrible loss or a short string of bad losses did most of the damage to an account. Had a trader cut his losses sooner, his bottom line would have been much higher. Traders dream of profits but freeze when a losing trade hits them. If you follow risk management rules, you’ll quickly get out of harm’s way instead of waiting and praying for the market to turn.

Markets can snuff out an account with a single horrible loss that effectively takes a person out of the game, like a shark bite. Markets can also kill with a series of bites, none of them lethal but combined they strip an account to the bone, like a pack of piranhas. The two pillars of money management are the 2% and 6% Rules. The 2% Rule will save your account from shark bites and the 6% Rule from piranhas.

The Two Worst Mistakes

There are two quick ways to ruin an account: not use stops and put on trades that are too large for that account’s size.

Trading without stops exposes you to unlimited losses. In the following chapters, we’ll discuss the principles and rules of risk control, but they will work only if you use stops.

There are several methods for setting stops, and we’ll discuss them in Chapter 54. We want to place our stops neither too far nor too close. At this point, just keep in mind that you must use stops. You have to know your maximum level of risk—it’s as simple as that. If you don’t know your maximum level of risk, you’re flying blind.

The other fatal error is overtrading—putting on trades whose size is too large for your account. This is like putting a huge sail on a small boat—a strong gust of wind will flip the boat over instead of making it go faster.

People put on trades that are too large for their accounts out of ignorance, greed, or a combination of both. There is a simple mathematical rule that gives you the maximum size for every trade, as you are about to see.

■ 50. The Two Percent Rule

One disastrous loss can do to an account what a shark does to a hapless swimmer. A poor beginner who loses a quarter of his equity in a single trade is like a swimmer who just lost an arm or a leg to a shark and is bleeding into the water. He’d have to generate a 33% return on the remaining capital simply to come back to even. The chances of him being able to do that are slim to none.

The typical victim of a “shark bite” loses more money. He loses confidence and becomes fearful of pulling the trigger. The way to avoid “shark bite” losses is by following the 2% Rule. It will limit your losses to a manageable size—to a normal businessman’s risk.

The 2% Rule prohibits you from risking more than 2% of your account equity on any single trade.

For example, if you have $50,000 in your account, the 2% Rule limits your maximum risk on any trade to $1,000. This is not the size of your trade—it’s the amount you put at risk, based on the distance from your entry to your stop.

Let’s say you decide to buy a stock for $40 and put a stop at $38, just below support. This means you’ll be risking $2 per share. Dividing your total permitted risk of $1,000 by your $2 risk per share tells you that you may trade no more than 500 shares. You are perfectly welcome to trade fewer shares—you don’t have to go the max every time. If you feel very bullish about that stock and want to trade the maximum permitted size, that number of shares will be limited to 500.

Good market analysis alone will not make you a winner. The ability to find good trades will not guarantee success. Markets are full of good analysts who destroy their accounts. You can profit from your research only if you protect yourself from sharks.

I’ve seen traders make 20, 30, and once even 50 profitable trades in a row, and still end up losing money. When you’re on a winning streak, it’s easy to feel you’ve figured out the game. Then a disastrous loss wipes out all profits and tears into your equity. You need the shark repellent of good money management.

A good trading system will give you an edge in the long run, but in the short run there is a great deal of randomness in the markets. The outcome of any single trade is close to a toss-up. A professional trader expects to be profitable by the end of the month or the quarter, but ask him whether he’ll make money on his next trade and he’ll honestly say he doesn’t know. That’s why he uses stops: to prevent negative trades from damaging his account.

Technical analysis can help you decide where to place a stop, which will limit your loss per share. Money management rules will help you protect your account as a whole. The single most important rule is to limit your exposure on any trade to no more than 2% of your account.

This rule applies only to money in your trading account. It doesn’t include your savings, equity in your house, retirement account, or Christmas club. Your trading capital is the money you’ve dedicated to trading. This is your true risk capital—the equity in your trading enterprise. If you have separate trading accounts for stocks, futures, and options, apply the 2% Rule to each account separately.

I’ve noticed a curious difference in how people react when they first hear about the 2% Rule. Newbies with small accounts often object that this number is too low. Someone asked me whether the 2% Rule could be increased when he was feeling especially confident about a trade, and I answered that it would be like adding extra length to the cord for bungee jumping because you like the view from the bridge.

Professionals, on the other hand, often say that 2% is too high and they try to risk less. You wouldn’t want to lose 2% of a million dollars on a single trade in one day. A hedge fund manager who consulted with me said that his project for the next six months was to increase his trading size. He never risked more than 0.5% of equity on a trade—and was going to teach himself to risk 1%. Good traders tend to stay well below the 2% limit. Whenever amateurs and professionals are on the opposite sides of an argument, you know which side to choose. Try to risk less than 2%—it is simply the maximum level.

Measure your account equity on the first day of each month. If you start the month with $100,000 in your account, the 2% Rule allows you to risk a maximum of $2,000 per trade. If you have a good month and your equity rises to $105,000, then your 2% limit for the next month will be—what? Quick! Remember, good traders can count! If you have $105,000 in your account, the 2% Rule allows you to risk $2,100 and trade a slightly bigger size. If, on the other hand, you had a bad month and your equity fell to $95,000, the 2% Rule will set your maximum permitted risk at $1,900 per trade for the following month. The 2% Rule links the size of your trades to your performance as well as account size.

The Iron Triangle of Risk Control

How many shares will you buy or sell short in your next trade? Beginners often choose an arbitrary number, such as a thousand or 200 shares. They may buy more if they’ve made money in their latest trade or less if they’ve lost money.

In fact, trade size should be based on a formula instead of vague gut feel. Use the 2% Rule to make rational decisions on the maximum number of shares you may buy or sell short in any trade. I named this process “The Iron Triangle of risk control” (Figure 50.1).

For example, when I volunteered to teach a yearlong course “Money and Trading” in a local high school and wanted to make the experience real for the kids, I opened a $40,000 account. I told my students that if, at the end of the school year, we made money, I’d give half the profit to their school and distribute the rest among class

FIGURE 50.1 The Iron Triangle of risk control.

Construct the Iron Triangle in three steps:

• A. Your maximum dollar risk for the trade you’re planning (never more than 2% of your account).
• B. The distance, in dollars, from your planned entry to your stop—your maximum risk per share.
• C. Divide “A” by “B” to find the maximum number of shares you may trade. You aren’t obligated to trade this many shares, but you may not trade more than this number.

participants. I also told them that their maximum risk per trade was one percent. A kid would stand up in class and make a case for buying Nokia at $16, with a stop at $14.50. “How many shares may we trade?”—I’d ask. With the maximum risk of $400 per trade and $1.50 risk per share, the kids would be allowed to buy 250 shares, with some leeway for commissions.

If you have a tiny account, you may end up trading the maximum permitted number of shares each time. As your account grows bigger, you may want to vary the size of your trades: say a third of the maximum for regular trades, two thirds for extra strong trades, and the full amount for exceptional trades. Whatever you do, the Iron Triangle of risk control will set the maximum number of shares you may trade.

The 2% Rule in the Futures Markets

A trader recently asked me how he could apply the Iron Triangle of risk control to trading e-mini futures in his $50,000 account. I replied:

• A. If you are trading a $50k account, the 2% Rule would limit your risk on any trade to $1,000. Let’s say you want to be conservative and risk only 1% of that account, or $500. That will be the first side of “the Iron Triangle of risk Control.”
• B. Suppose you look at your favorite e-minis and want to sell a contract short at 1810, with a profit target at 1790 and a stop at 1816. You’ll be risking 6 points, and since one point in e-minis is worth $50, your total risk will be $300 (plus commissions and possible slippage). That will be the second side of your Iron Triangle of risk control.
• C. Close the triangle by dividing “a” by “b” to find the maximum size you may trade. If your maximum risk is $500, then one contract, but if $1,000, then three.

Please meet two futures traders, Mr. Hare and Mr. Turtle, each with a $50,000 account. The agile Mr. Hare sees that the average daily range in gold is about $30, worth $3,000 per day for a single contract. The daily range in corn is about 10 cents, worth $500 per day for a single contract. He thinks that if he can catch just half of a day’s range, he’ll make $1,500 per contract in gold, while the same level of skill will bring him only $250 in corn. Mr. Hare logs into his brokerage account and buys two contracts of gold.

The cautious Mr. Turtle has a different arithmetic. He begins by using the 2% Rule to cap his maximum risk per trade at $1,000. He sees that it would be impossible to place a meaningful stop while trading gold which can move $3,000 a day. To buy gold in his account would be like grabbing a very large tiger by a very short tail. If, on the other hand, he trades corn, he’ll have good staying power. That tiger is smaller and has a longer tail, which he can wrap around his wrist. Mr. Turtle buys a contract of corn. Who do you think is more likely to win in the long run, Mr. Hare or Mr. Turtle?

Futures markets are more deadly than stocks not because of any special complexity. Sure, they have some specific angles, but those aren’t too hard to learn. Futures kill traders by seducing them with paper-thin margins. They offer enormous leverage –ability to trade large positions on a 5% margin. This works wonders when the market moves in your favor, but it slices your wallet when the market turns against you.

You can succeed in futures only with sensible risk control, using the 2% Rule.

• A. Calculate 2% of your account value—this will be the maximum acceptable risk level for any trade. If you have $50,000 in your futures account, the most you can risk is $1,000.
• B. Examine the charts of the market that interests you and write down your planned entry, target, and stop. Remember: a trade without these three numbers is not a trade but a gamble. Express the value of the move from your entry to your stop in dollars.
• C. Divide A by B, and if the result turns out to be less than one, no trade is permitted—it means you cannot afford to trade even one contract.

Let’s review two market examples, featuring similar chart patterns (Figure 50.2). Let’s assume you have a $50,000 account, which permits you to risk the maximum of $1,000 per trade.

You can trade futures reasonably safely only with strict money management. The leverage of futures can work for you—as long as you stay away from those contracts that can kill your account.

A professional futures trader surprised me early in my career when he told me he spent a third of his time on risk management. Beginners jump into trades without giving them much thought. Intermediate-level traders focus on market analysis. Professionals dedicate a massive proportion of their time to risk control—and take money away from beginners and amateurs.

FIGURE 50.2 Daily charts with 13- and 26-day EMAs and Autoenvelopes. The Impulse system and MACD-Histogram 12-26-9. (Charts by Tradestation)

The 2% Rule in Futures—Silver and Wheat

Suppose you want to buy silver at the right edge of this chart. Prices have traced a double bottom with a false downside breakout. MACD-Histogram has traced a bullish divergence. The Impulse system has turned blue, permitting buying. The nearby futures contract trades at $21.415 a few minutes before the close.

You decide that if you buy, your profit target will be near $23, halfway from the EMA to the upper channel line. Your stop will be at $20.60, the level of the latest low. You’ll be risking $0.815/oz trying to make about $1.585/oz—a 2:1 reward/risk ratio, an acceptable number.

Are you allowed to take this trade? Absolutely not! That $0.815/oz risk per contract translates into $4,075 total risk, since one contract covers of 5,000 ounces of silver. Remember, your maximum permitted risk is $1,000. If you’re eager to take this trade, you may buy a single mini-contract. It covers only 1,000 ounces of silver, meaning you’ll risk $815. Best wishes for that sensible trade.

Now, suppose you’re interested in buying wheat at the right edge of this chart. Its technical picture looks similar: a double bottom with a bullish divergence of MACD-Lines and MACD-Histogram. The Impulse system has turned blue, permitting buying. Shortly before the close, prices are near 658 cents.

You decide that if you enter there, your target will be near 680 cents, near the upper channel line. Your stop will go to 652 cents, the level of a recent low. You’ll be risking 10 cents/bu, trying to make about 22 cents/bu—a reward/risk ratio of 2:1, similar to that of silver.

Are you allowed to take this trade? Yes! That 10 cent risk per contract translates into $500 total risk, since the contract covers 5,000 bushels of wheat. Remember, your maximum permitted risk is $1,000. If you’re very bullish, you may even buy two contracts.

You must keep in mind that when trading futures the technical pictures of different markets may look similar, but you must base your decisions to trade or not to trade on money management rules.

If you cannot afford to trade a certain market, you can still download its data, do your homework, and paper trade it as if you were doing it with real money. This will prepare you for the day when your account grows big enough or the market grows quiet enough for you to put on a trade.

■ 51. The Six Percent Rule

A piranha is a tropical river fish not much bigger than a man’s hand, but with a mean set of teeth. What makes it so dangerous is that it attacks in packs. If a dog, a donkey, or a person stumbles into a tropical stream, a pack of piranhas can attack with such a mass of bites that the victim collapses. A bull can walk into a river, be attacked by a pack of piranhas, and a few minutes later only its bones will be left in the water. A trader, who keeps sharks at bay with the 2% Rule, still needs protection from piranhas. The 6% Rule will save you from being nibbled to death.

Most of us, when we find ourselves in trouble, start pushing harder. Losing traders often take on bigger positions, trying to trade their way out of a hole. A better response to a losing streak is to step aside and take time off to think. The 6% Rule sets a limit on the maximum monthly drawdown in any account. If you reach it, you stop trading for the rest of the month. The 6% Rule forces you to get out of the water before piranhas get you.

The 6% Rule prohibits you from opening any new trades for the rest of the month when the sum of your losses for the current month and the risks in open trades reach 6% of your account equity.

We all go through periods when we are in tune with the markets, taking one profit after another. When everything we touch turns to gold, that’s the time to trade actively.

There are other times when everything we touch turns into a completely different substance. We go through periods when our systems go out of sync with the market, delivering one loss after another. It’s important to recognize such dark periods and not push yourself but rather step back. A professional on a losing streak is likely to take a break, continue to monitor the market, and wait to get in gear with it again. Amateurs are more likely to keep pushing until their accounts become crippled. The 6% Rule will make you pause while your account is still largely intact.

The Concept of Available Risk

Before you put on a trade, ask yourself: what would happen if all your trades suddenly turned against you? If you used the 2% Rule to set stops and trade sizes, the 6% Rule will limit the maximum total loss that your account may suffer.

• 1. Add up all your losses taken this month.
• 2. Add up your risks on all currently open trades. The dollar risk of any open position is the distance from your entry to the current stop, multiplied by the trade size. Suppose you’ve bought 200 shares for $50, with a stop at $48.50, risking $1.50 per share. In that case, your open risk is $300. If that trade starts going your way and you move your stop to breakeven, your open risk will become zero.
• 3. Add the two lines above (losses for the month plus risks on open trades). If their sum comes to 6% of what your account equity was at the beginning of the month, you may not put on another trade until the end of the month or until the open trades move in your favor, allowing you to raise your stops.

The 6% Rule changes the usual question—“do I have enough money for this trade?”—to a much more relevant one—“do I have enough risk available for this trade?” That limit—risking no more than 6% of your account equity in any given month—keeps your total risk under control, ensuring long-term survival. Your total available risk for the month is 6% of your account equity, and the first question to ask yourself when considering a new trade is “Considering all my open and closed trades for this month, do I have enough available risk for this trade?”

You know how much money, if any, you’ve lost during the current month. It’s easy to calculate how much money you have at risk in your open trades. If your previous losses for this month plus your risk on existing trades expose you to a total risk of 6% of your account equity, you may not put on another trade.

If the 6% Rule doesn’t allow you to put on a new trade, continue to track the stocks you’re interested in. If you see a trade you really want to take, but don’t have available risk, consider closing out one of your open trades to free up some risk.

If you are near the 6% limit but see a very attractive trade you wouldn’t want to miss, you have two options. You can take profits on one of your open trades to free up available risk. Alternatively, you may tighten some of your protective stops, reducing your open risk. Just be sure that in your eagerness to trade you do not make your stops too tight (see Chapter 54).

Let’s review an example, assuming, for the sake of simplicity, that a trader will risk 2% of his account equity on any given trade.

• 1. At the end of the month, a trader has $50,000 in his account, with no open positions. He writes down his maximum risk levels for the month ahead—2% or $1,000 per trade and 6% or $3,000 for the account as a whole.
• 2. Several days later he sees a very attractive stock A, figures out where to put his stop, and buys a position that puts $1,000, or 2% of his equity, at risk.
• 3. A few days later he sees a stock B, and puts on a similar trade, risking another $1,000.
• 4. By the end of the week he sees a stock C, and buys it, risking another $1,000.
• 5. The next week he sees a stock D, more attractive than any of the three above. May he buy it? No, he may not, because his account is already exposed to 6% risk. He has three open trades, risking 2% on each, which means he may lose 6% if the market turns against him. The 6% Rule prohibits him from taking any more risks at this time.
• 6. A few days later, the stock A rallies and the trader moves his stop above breakeven. Stock D, which he wasn’t allowed to trade just a few days ago, still looks very attractive. May he buy it now? Yes, he may, because his current risk is only 4% of his account. He is risking 2% in stock B and another 2% in stock C, but nothing in stock A, because its stop is above breakeven. The trader buys stock D, risking another $1,000 or 2%.
• 7. Later in the week, the trader sees stock E, which looks very bullish. May he buy it? Not according to the 6% Rule because his account is already exposed to a combined risk of 6% in stocks B, C, and D (there is no longer a risk in stock A). He may not buy stock E.
• 8. A few days later, stock B hits its stop. Stock E still looks attractive. May he buy it? No, since he already lost 2% on stock B and has a 4% exposure to risk in stocks C and D. Adding another position at this time would expose him to more than 6% risk per month.

Three open trades isn’t a lot of diversification. If you wish to make more trades, set your risk per trade at less than 2%. For example, if you risk only 1% of your account equity on any trade, you may open up to six positions before maxing out at the 6% limit. In trading a large account, I use the 6% Rule but tighten the 2% Rule to well under 1%.

The 6% Rule allows you to increase your trading size when you’re on a winning streak but makes you stop trading early in a losing streak. When markets move in your favor, you can move your stops to breakeven and have more available risk for new trades. On the other hand, if your positions start going against you and hitting stops, you’ll quickly stop trading and save the bulk of your account for a fresh start next month.

The 2% Rule and the 6% Rule provide guidelines for pyramiding—adding to winning positions. If you buy a stock and it climbs high enough to raise your stop above breakeven, then you may buy more of the same stock, as long as the risk on the new position is no more than 2% of your account equity and your total account risk is less than 6%. Handle each addition as a separate trade.

Many traders go through emotional swings, feeling elated at the highs and gloomy at the lows. Those mood swings will not help you trade, just the opposite. It is better to invest your energy in risk control. The 2% and the 6% Rules will convert your good intentions into the reality of safer trading.

■ 52. A Comeback from a Drawdown

When the level of risk goes up, our ability to perform goes down. Beginners make money on small trades, start feeling confident, and jack up trade size. That’s when they start losing. The increased level of risk on bigger positions makes them stiffer and less nimble, and that’s all it takes to fall behind.

I saw a great example of that while running a psychological training group for a day-trading firm in New York. That firm taught its traders a proprietary stock trading system and let them trade the firm’s capital on a profit-sharing basis. Their two top traders were making up to a million dollars a month; others made much smaller profits but quite a few lost money. The firm’s owner asked me to come and help losing traders.

They were shocked to hear that a psychiatrist was coming and loudly protested they “weren’t crazy.” The owner provided the motivation by telling his worst performers they had to participate—or else leave the firm. After six weeks, the results were such that we had a waiting list for the second group.

Since the company taught traders its own system, we focused on psychology and risk control. In one of our first meetings, a trader complained that he had lost money each day for the past 13 days. His manager, who sat in on our meetings, confirmed that the fellow was using the firm’s system but couldn’t make any money. I began by saying that I’d take off my hat for anyone who lost 13 days in a row and had the emotional strength to come in and trade the next morning. I asked the man how many shares he traded, since the firm set a maximum for each trader. He was permitted to buy or sell up to 700 shares at a clip, but voluntarily reduced it to 500.

I told him to drop his size down to 100 shares until he had a week with more winning days than losing and was profitable overall. Once he cleared that hurdle for two weeks in a row, he could go up to trading 200 shares at a clip. Then, after another 2-week profitable period, he could go up to 300 shares, and so on. He was allowed a 100 share increment after two weeks of profitable trading, but if he had a single losing week, he’d have to drop back to the previous level. In other words, he had to start small, increase the size slowly, but drop it fast in case of trouble.

The trader loudly objected that 100 shares weren’t enough to make money. I told him to stop kidding himself, since by trading 500 shares he wasn’t making any money either, and he reluctantly agreed. When we met a week later he reported that he had four profitable days and was profitable overall. He made very little money because of the 100 share size, but he was ahead of the game. He continued to make money during the next week and then stepped up to 200 shares. After another profitable week he asked, “Doc, do you think this could be psychological?” The group roared.

Why would a man lose while trading 500 shares, but make money trading 100 or 200?

I took a $10 bill out of my pocket and asked whether anyone in our group would like to earn it by climbing on top of our long and narrow conference table and walking from one end to the other. Several hands went up. Wait, I said, I have a better offer. I’ll give $1,000 cash to anyone who comes with me up to the roof of our 10-story office building and uses a board as wide as this table to walk to the roof of another 10-story building across the boulevard. No volunteers.

I started egging on the group—the board will be sturdy, we’ll do it on a windless day, I’ll pay $1,000 cash on the spot. The physical challenge would be the same as walking on the conference table, but the reward so much greater. Still no takers. Why? Because if you lose your balance on the table, you’ll jump down a couple of feet and land on the carpet. If you lose your balance between two rooftops, you’d be splattered on the asphalt.

The higher levels of risk impair our ability to perform. You need to train yourself to accept risks slowly and in well-defined steps. Depending on how actively you trade, those steps can be measured in weeks or months, but the principle remains the same—you need to be profitable during two units of time to go up a step in your risk size. If you lose money during one unit of time, drop down a step in your risk size. This is especially useful for people who want to return to trading after a bad drawdown. You need to gradually work your way back into trading, without an upsurge of fear.

Most beginners are in a hurry to make a killing, but guess who gets killed. Unscrupulous brokers promote overtrading (putting on trades that are too big for your account) to generate commissions. Some stockbrokers outside the United States offer a “shoulder” of 10:1, allowing you to buy $10,000 worth of stock for every $1,000 you deposit with the firm. Some forex houses offer a deadly “shoulder” of 100:1 and even 400:1.

Putting on a trade is like diving for treasure. There is gold on the ocean floor, but as you scoop it up, remember to glance at your air gauge. The ocean floor is littered with the remains of divers who saw great opportunities but ran out of air. A professional diver always thinks about his air supply. If he doesn’t get any gold today, he’ll go for it tomorrow. He needs to survive and dive again. Beginners kill themselves by running out of air. The lure of free gold is too strong. Free gold! It reminds me of a Russian saying—the only free thing is this world is cheese in a mousetrap.

Successful traders survive and prosper thanks to their discipline. The 2% Rule will keep you safe from the sharks, while the 6% Rule will save you from the piranhas. If you follow these rules and have a reasonable trading system, you’ll be miles ahead of your competitors.

A Trading Manager

It used to puzzle me why institutional traders as a group performed so much better than private traders. An average private trader in the United States is a 50-year-old married, college-educated man, often a business owner or a professional. You would think this thoughtful, computer-literate, book-reading individual would run circles around some loud 23-year-old who used to play ball in college and hasn’t read a book since his junior year. In reality, institutional traders as a group outperform private traders year after year. Is it because of their fast reflexes? Not really, because young private traders perform no better than older ones. Nor do institutional traders win because of training, which is skimpy in most firms.

A curious fact: when successful institutional traders go out on their own, most of them lose money. They may lease the same gear, trade the same system, and stay in touch with their contacts, but still fail. After a few months, most cowboys are back in head-hunters’ offices, looking for a trading job. How come they could make money for the firms but not for themselves?

When an institutional trader quits his firm, he leaves behind his manager, the person in charge of discipline and risk control. That manager sets the maximum risk per trade. It is similar to what a private trader can do with the 2% Rule. Firms operate from huge capital bases and their risk limits are much higher in dollar terms but tiny in percentage terms. A trader who violates his risk limit is fired. A private trader can break the 2% Rule and nobody will know, but an institutional manager watches his traders like a hawk. A private trader can throw confirmation slips in a shoebox, but a trading manager quickly gets rid of impulsive people. He enforces discipline that saves institutional traders from disastrous losses, which destroy many private accounts.

In addition to setting a risk limit per trade, a manager sets the maximum allowed monthly drawdown for each trader. When an employee sinks to that level, his trading privileges are suspended for the rest of the month. A trading manager breaks his traders’ losing streaks by forcing them to stop trading if they reach their monthly loss limit. Imagine being in a room with co-workers who actively trade, while you sharpen pencils and get asked to run out for sandwiches. Traders do all in their power to avoid being in that spot. This social pressure creates a serious incentive not to lose.

People who leave institutions know how to trade, but their discipline is often external, not internal. They quickly lose money without their managers. Private traders have no managers. This is why you need to become your own manager. The 2% Rule will save you from disastrous losses, while the 6% Rule will save you from a series of losses. The 6% Rule will force you to do something most people cannot do until it’s too late—break a losing streak.