10 Things You Need to Know About Risk, Risk Management and Trading
I will start this piece by saying that I am not bullish or bearish, I don't make market calls, or predictions and I don't have opinions about the markets that I trade. I just follow my process, which is based on risk management, money management, price and moving averages. I lead off with this statement so that readers do not think that I am making some type of a market call by talking about risk management and downside protection while we are at all time highs. I follow core concepts:
Respect price, respect risk and always be prepared for any outcome.
With Global markets at or near all time highs, and the money flowing in for many, now seemed to be an opportune time to remind ourselves that every day is a good day to focus on risk management. All of the greatest traders, Soros, Druckenmiller, Tudor Jones and Kovner, to name just a few, have a laser like focus on capital preservation and risk management. They have all publicly stated that risk management and their ability to cut losses short is the cornerstone of their success. Paul Tudor Jones, a Billionaire Trader, is frequently the most quoted and has said:
“…at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.”
“Don’t focus on making money; focus on protecting what you have.”
“I am always thinking about losing money as opposed to making money.”
Bruce Kovner, another Billionaire Trader, said in Market Wizards: "First, I would say that risk management is the most important thing to be well understood".
With that being said, here are 10 key concepts regarding risk management that I focus on:
1. Experienced, high level traders focus first on how much they can lose in a trade and how to manage risk.
Others tend to focus 100% on how much money they think they can make, with little or no consideration given to potential losses and how to manage them. Skilled traders know if they focus on protecting the downside, the upside will take care of itself. In a major bull market, it should not be very difficult to find uptrends and winning positions to get into. A quick scan of the new 52 week high list shows very strong uptrends across the board. Getting into an uptrend is basic trading 101. Skilled traders let the upside trades go to work, and focus on eliminating the losers that can cut into their equity.
2. Stocks and markets often go down faster than they go up
The adage goes, that stocks take the stairs up and the elevator down. Fear and greed are the two emotions most prevalent in stock markets, and fear is the strongest of the two. It has been said that markets look their best at all time highs, which may be true, but they can also turn quickly. The S&P 500 bottomed in October of 2002 at 768, and by October of 2007, it topped out at 1576, a gain of over 105% in 5 years. By March of 2009, just 17 months later, it made a new low of 666. Five years on the way up (stairs), less than 1.5 years on the way down (elevator).
3. You will have losing trades
Some of the greatest traders ever discuss being profitable on less than 50% of their trades. PTJ discusses strategies to be profitable being right just 1 in 5 attempts. Soros has been said to have "maybe" a 30% to 50% win rate, by his former colleague Scott Bessent.
The fact is that anyone who trades is going to have their share of losers. It doesn't matter what your system's historical win rate is, how good the chart "looks" or what data you think you have, the very next position that you go into can move against you, it is an unavoidable fact. I go into every single trade knowing that it can be stopped out at any time, and size my account properly for overall risk and individual position risk. Once traders accept that each and every trade can go against them, it should allow them to prepare for the reality of it and try to minimize the damage.
4. You will have a string of losing trades
To expound on the point above, any trader or system, over time, is going to run into a string of losing trades. Many greats discuss trading smaller when they hit these losing periods. By using fixed percentage risk sizing (risking the same percentage of account equity per trade) a trader ensures that they will be trading smaller in drawdowns and losing periods, because trade size is dictated by account equity. Lower equity means less $ at risk per trade. As their performance improves, net trade size will increase in line with equity.
The key here is to be prepared for losing periods, to stick to the plan, and to not try to revenge trade their way out of a drawdown or losing period. Markets don't beat traders, traders beat themselves because they try to impose their will on the market. That is 100% a losing proposition.
5. Most traders think they can mentally handle larger drawdowns than they really can
My trading mentor taught me "traders can handle unlimited volatility...on the upside". Many seem to feel like they can handle volatility as long as the market is trending in their direction and the P/L keeps creeping up. We are all brave with the wind at our backs. Once any significant pullback or drawdown happens and traders see their equity contract and the red days add up, many often panic and cut technically sound positions just to stop the pain of the drawdown. More often than not, markets turn around right after they flip the panic switch and the trade resumes it's uptrend , without them in it. One great trader, whose names escapes me now, said that in realty traders can handle about one half of the drawdown that they think they can. Essentially if one thinks they can handle a 30% drawdown, they are really probably wired for about a 15% contraction. When your $100K account becomes an $80K account, or your $1 million account says $800,000, the reality of drawdowns sets in and most, if not all of us, wish we had dialed back the risk sooner.
6. Stop losses are essential, but they do not cap your risk
Great traders know what gets them out of a position before they get into it. They ask two questions. How will I know that I am wrong and what will I do to minimize the damage? Soros and others are famous for being great loss takers, and cutting positions with zero remorse or hesitation when the market proves them wrong. Stop losses are a great way to minimize risk, but they do not put a cap on it. Positions, both long or short, can gap against a trader for any reason, or no reason, at any time. Careful position sizing should be used to calculate risk, but traders need to be prepared for a gap against them at any time, which can cause a losing trade to cost more than the trader initially planned for. Trading smaller in size than one thinks they should is one way to minimize the damage done by gaps through a stop.
7. Most traders overtrade and leave themselves overexposed in one or more ways
I will defer to Bruce Kovner, again, whose second piece of advice to traders is "undertrade, undertrade, undertrade". He said his experience with novice traders is "that they trade three to five times too big". A detailed discussion of overtrading could take up an entire book. In my opinion, overtrading is the single most damaging thing a trader can do to their accounts. Overtrading does not just mean trading too frequently. It can also mean having too many open positions, too many correlated positions, having too much money at risk in positions or accounts as a whole, and taking on significantly more risk than they need to. While this may seem like a good idea on the way up, when they start to unwind the damage can be swift and severe.
8. The best true hedge is cash and reduced exposure
Some think that they can counter long positions, and or overexposure by hedging away risk using derivatives or shorting techniques. While a 130/30 long/short strategy may sound great, it may not be the best approach for most. Some people make a living driving 200 miles per hour, but for most of us, that would likely result in a less than optimal outcome. Derivatives do not always move the way they are expected to, due to a variety of variables and short positions can go up while long positions go down. I had this happen to me before years ago, and I noticed it was usually before Fed meetings. Then it occurred to me that traders may simply be closing out positions ahead of the Fed, which is why all of my positions went against me. I never confirmed it, but the theory did not seem unreasonable. I have watched levered short ETFs lose value while the market they were short was also losing value.
In times of extreme volatility or panic, all assets can decline in value as traders or funds have to sell anything liquid to raise cash and/or meet redemptions. Any hedging strategy that involves extra exposure may often result in extra risk. While I am sure someone can produce a statistical report that shows they have exceptions to this statement, the general concept applies. The absolute best hedges are cash and reduced exposure. Cash is cash and it doesn't fluctuate in value.
9. Ignore predictions, forecasts and market calls
I realized log ago that nobody can consistently call market moves. Not the CNBC Guru, or internet Superstar. If PTJ and Soros are in the 50% or so camp, what makes us think that anyone else can "call" markets better than these Billionaires can trade them? Predictions are no better than a coin toss. Incorrect predictions are swept under the rug, and when one lands right, the forecaster claims Guru status.
Traders often allow themselves to hold onto a losing position longer than they should because their favorite guru recommended it on TV or in a newsletter, or a Wall Street firm has a buy or upgrade rating on it. The guru/firm isn't going to send you a check to make you whole in the position and they aren't going to call you if they change their view on the stock. I read long ago to develop my own method for trading or be trapped into trading off other's opinions. I ignore opinions, regardless of how intelligent they may sound to some, and stick to price and moving averages.
10. Realize that any outcome is always possible and that markets or stocks can unwind at any time for any reason, or for no reason at all
For some reason, many believe that to trade profitably they need to know "why" markets move the way the do. Fact is, nobody really knows why. Markets are made up of millions of participants and computers, all with a different process. One reason that computers outperform humans for the most part is computers don't waste time trying to rationalize things, they just follow the process. Once we accept that markets can up go because they are and go down because they are, we can accept that not every move has to be explained or justified. Holding onto downtrends because the fundamentals are "good" or the chart "looks good", and ignoring the fact that the trade is moving against you can be very costly.
