My Basic Rules For Risk Management
A common question I hear is how do you manage risk? I am a quantitative trader therefore everything I design has risk management built in. I use three risk management techniques in all of my systems, stop losses, signals and profit target.
Stops and Profit Targets Based on Volatility
Most people in the mentor space say you’re going to have to use huge stops. Most people don’t like that answer, but when you test stop losses of any system, the wider the stop, the more accurate a signal becomes. If you’re not comfortable with a large stop as a trader, then you shouldn’t be trading. The best kinds of stops to use are based on volatility which is dynamic and adaptive versus using a hard stop of a certain dollar amount.
Imagine the chart below is a stock. Most retail traders see this stock and say where the arrow is pointing is a breakout. They will manually buy at the arrow and place a stop at $100 because that is all they can afford to lose, nonsense. This technique is not based in volatility, so it is not dynamic or adaptive.
Now let’s create a stop and profit target based in volatility using this chart. First you need to look at the current volatility of the stock, for this chart we have yesterday’s high and low. We want to trade within the range of the passed day’s volatility. The range is equal to the high minus the low. Based on this data we want to place our volatility-based breakout at the lowest point of our range, yesterday’s low. We can find our profit target by taking our range and adding it to yesterday’s high. As you can see this gives us a wider stop so instead of a $100 stop this may mean $1000 stop. If you cannot handle a $1000 dollar stop scale back. Your profit targets are now adapted to the volatility of yesterday and adapted to the real risk in the market.
This is just a simplified example. In practice you would want stops adapted generally for a volatility of the range in which you’re trading over a time horizon, the last 20 days, 21 days or 30 days. Just like anything in the trading world do not take this technique and run with it. Learn to code and test this strategy on your own.
This can all be applied to day trading as well. There are tons of other ways to decide a stop, but the range is an easy concept, high minus low. Then having a profit target also rewards you for that volatility. Penny stocks are extremely volatile.
Scale Down to the Worst-Case Scenario for Your Account
The next thing you need to do is scale down to the worst-case scenario for your account. In reality you should never bet more than 2% of your account value. On average, you should only bet 1%. If you had $100,000, the most comfortable level is between $1000-$2000 per bet. Then using simple math 1% of a $1,000 account would leave you with only $10 to bet. If you have a strategy that is coded, tested, validated, and the edge is in your favor, you could go on a losing streak even 40 times, then you only need a couple of trades to come out ahead.
Most gurus will not tell you to only trade 1-2% of your account because they want you to believe in the dream of taking a couple of thousand dollars and turning it into significant sums. The few who can do this are the exception to the rule. It takes money to make money.
Take Uncorrelated Bets
If you are trading one asset class, you may want to try something different. If my test proven system is trading the S&P 500, all stocks follow the S&P 500, so the stock market is covered. The next thing I want to do is create a tested system for something that is not correlated to the S&P like gold, silver, oil, natural gas or some T-bond. I would then only trade those two asset classes. Ray Dalio also talks about how each uncorrelated bet you take, reduces your risk by a factor of five, which is huge up to a certain threshold. After a certain threshold of uncorrelated bets, you cap out on reducing risk. If you’re a small account trader, $20,0000, or $30,000 to your name, design strategies on one asset class and design another strategy on another asset class that has no correlation.
Those are the three risk management techniques to keep in mind. Understand for me, I don’t talk about risk management a lot because as a quantitative trader it’s always there. Just remember my three techniques for risk management are volatility stops, only taking bets about 1-2% of your account and taking uncorrelated bets of at least two asset classes.