Placing a trade with a predetermined stop-loss point can be compared to placing a bet: the more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure or heat from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2% on each of five instrument & has a total heat of 10%, as does a portfolio risking 5% on each of two instruments. Our studies of heat show several factors, which are: Trading systems have an inherent optimal heat. Setting the heat level is far and away more important than fiddling with trade timing parameters. Many traders are unaware of both these factors. COIN FLIPPING One way to understand portfolio heat is to imagine a series of coin flips. Heads, you win two; tails, you lose one is a fair model of good trading. The heat question is: what fixed fraction of your running total stake should you bet on a series of flips?
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rssMANAGING RISK
Well, perhaps the best way is to emulate some of the trading principles used by the pundits of yesteryear who beat the stock market no matter the emotions and mechanics of the institutional herd. For instance:
Bernard Baruch – Some 70 years ago, he would research a stock, buy it, and then each time the stock rose 10% from his purchase price, buy an additional amount equal to his first purchase. If the stock began declining he would sell everything he had bought when the drop equaled 10% of its top price …
Baron Rothschild – His success formula was centered on the famous quote attributed to him – “I never buy at the bottom and I always sell too soon.” …
Jesse Livermore – This legendary speculator profited enormously by calling the various 1921 – 1927 advances correctly. In 1929 he reasoned that the market was overvalued, but finally gave up and became bullish near the top in the fall of that infamous year.
He quickly cut his losses, however, and switched to the “short side.” Livermore listed three major points for his success:
1. Sensitivity to mob psychology
2. Willingness to take a loss
3. Liquidity, meaning that stock positions should not be taken that cannot be sold in 15 minutes “At the market” …
Addison Cammack – A stockbroker from Kentucky who swore by the two-point stop-loss rule. “If you’re wrong,” he said, “you might as well be wrong by two points as ten.” He followed this method successfully and was one of the few bears to make a fortune on Wall Street and keep it …
Interestingly, all of these disciplines have one thing in common. They all adhere to Benjamin Graham’s mantra, “The essence of portfolio management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”
Well, perhaps the best way is to emulate some of the trading principles used by the pundits of yesteryear who beat the stock market no matter the emotions and mechanics of the institutional herd. For instance:Important goals for traders
1) Risk management goals – Goals pertaining to trade sizing and drawdowns;
2) Idea generation goals – Goals pertaining to the process of generating sound trading ideas and formulating these into plans;
3) Execution goals – Goals pertaining to implementing trade ideas/plans so as to maximize reward and minimize risk;
4) Position management goals – Goals pertaining to the management of positions once they’re entered, including hedging and scaling in/out;
5) Portfolio management goals – Goals pertaining to achieving good diversification among ideas and allocating capital effectively to those ideas;
6) Self-management goals – Goals pertaining to maintaining a constructive mindset for optimal decision-making;
7) Personal, non-trading goals – Goals that reflect desired outcomes in areas of life outside trading that might spill over into trading performance, including physical fitness, relationships, spirituality, etc.