risk management to improve the profitability of trading methods. Let me
show you how.
Although there are many reasons why trading systems look bad during
testing, one common problem is that a system has shown a few huge losses
during the testing period. Here is how risk management concepts can help.
Make a histogram of all the losses, making the left axis the size of the
loss and the bottom axis the number of times that the loss occurred. What
you will find is that most of the losses are moderate but there are several
whopping losses. Simply look at the histogram to see where you could put
a money management stop that would cut out most of the major losers but
only account for a few trades.
For example, assume that you have 100 losses in your test. Ninety-five
of the losses are $1,000, which you can financially (and psychologically)
handle. However, there are five that are greater than $1,000, including a
couple that are greater than $5,000. Change the rules for exiting positions
to either the signal of the trading system or $1,000, whichever shows the
least loss. You will find that you will reduce the total losses typically by
20 percent to 40 percent.
Once in a blue moon, a trade will show a big open loss only to turn
around and move to a profit position. However, that outcome is so rare that
this simple technique can turn many losing systems into profitable systems.
In addition, it may significantly enhance nearly all systems.
HOW BIG A POSITION
SHOULD I TAKE?
Here’s what I recommend for weighting on each position. Why not start
with 0.5 percent for each method/pair? In other words, let’s say that you are
trading trend analysis, channel breakout, and the Conqueror. You would
risk a maximum total of 1.5 percent for each pair. That means that you will
risk 0.5 percent for each method. Note that you could, at any given time,
be risking zero, 0.5 percent, 1.0 percent, or 1.5 percent. Note that you will
get to the maximum risk in only a few rare circumstances. I’ll come back
to this in a minute.
I recommend 0.5 percent in each position not because it is the best
amount of risk to take but because it is a good starting point for traders.
This amount is usually a small amount to lose for anyone.
A beginning trader should likely start with 0.25 percent for each technique/
instrument pair. That means that using four techniques on one given
pair will mean that the total risk could get as high as 1.0 percent (though
this is highly unlikely).
Then, start to increase the amount of risk as you feel more confident
about the techniques. Go to 0.3 percent, then 0.4 percent, and so on up to
the point that you feel comfortable. You probably don’t want to get to a
point where you have a total risk of over 5 percent in any given pair. But
the point is to develop the confidence to increase risk as you develop as
a trader.
Use the concept of changing the size from Kelly and apply to the fixed fractional.
THE BOTTOM LINE: DIVERSIFY
THROUGH TIME
What is the bad news of using strict risk management? Not much.
First, you have to be much more disciplined in your trading. You have
to do a little more work to figure out your risk on each position and the
total portfolio risk. Frankly, this is no big task.
Second, your return may go down, though this is not a given. For most
people, their returns will skyrocket. Generally, traders with powerful risk
management rules will not have years that put them in the top 10 percent
every year. It is difficult to have 100 percent years using these rules. It takes
a lot of risk to make a ton of money.
However, the risk-adjusted return (the return in a portfolio divided by
the standard deviation of the monthly returns) will shoot higher. You will
be producing lower returns but with sharply reduced risk.
In addition, although you will not be number one in any given year,
you will be number one for any given five years. It was largely using this
technique that got me a top ranking for my Macro hedge fund and for my
stock-picking letter. I was never top ranked for any given year but always
ended up in the top 25 percent. After a few years of being in the top 25 percent,
I ended up at or near the number one ranking. It was this pattern of
consistently high returns that did the trick.
This chapter has put you in a very elite group. You now know more
about risk management than probably 95 percent of investors. You now
know how to control risk at a level only the most sophisticated hedge funds
do. This is a huge advantage in the fight for forex profits.
Let me prove this. Most institutional investors are not allowed to have
less than 97 percent of their money under management to be in cash. They
certainly aren’t allowed to be short. This applies to mutual funds, segregated
funds, and union funds. The manager would be fired if they were
to go 50 percent into cash! The basic concept is that the investor wants
to invest in, say, natural resources, and then they buy a natural resources
mutual fund. The manager is supposed to stay fully invested in natural resources
stocks and not deviate from that mandate. So they have to stay
fully invested in natural resource stocks even in the midst of the bear
market.
Now, grab the next 100 retail investors on the street and ask them if
they use any risk management. The answer from only a few will be that
they use some protective stop orders. The rest will think you are nuts.
That leaves only some hedge funds that use proper money management.
Welcome to the risk management elite!
Sharply controlling the risk in your portfolio can keep you in the game
and even beat the game. Use the fixed fractional or Kelly method to calculate
how large your position should be, use some type of portfolio risk
management to control the total risk in your portfolio, and make sure that
you have the right attitude to keep trading. If you follow these rules, you
will find a sharp increase in both your profits and your confidence.
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
