Risk / Reward
The essence of a trailing stop loss is that each time the market moves higher, the risk reward profile of the trade remains similar to the initial risk reward profit. This is called maintaining the risk/reward profile. A trader should avoid placing a trailing stop loss at levels where they are risking more once they move their stop loss, than they were risking initially. An example of this would be as follows. Let’s say an investor placed a trade on IBM where he was looking to make 6 percent and willing to risk 3% of a move against him on the trade. After the market moved 2% the trader plans to move the stop loss up to his initial entry price. This strategy would create the same risk-reward ratio since the trader is risking 2% (the difference between the current market which moved 2%) and the planned gain which is an additional 4%. If the trader moved the trailing stop up to 1% below his initial entry point, after the market moved 2%, then the risk-reward profile would be risking 3% (2% to minus 1%) to make 4%, which is a different ratio then the initial risk reward.
Along with stop losses and take profit levels, determining the optimal bet size is a very important part of creating a profitable trading strategy. Sticking to a strategy that preserves a trader’s capital and avoids ruin should be on an investor’s mind when determining the appropriate capital to place on a trade. There are many mathematical models which including Monte Carlo Simulation and the Kelly rule which help statisticians determine the optimal bet size for a systematic trading strategy. A simulation will allocate an amount of capital to a strategy and historically step through time to determine the best way to allocate capital per trade. Realistically, there are a few potential ways to allocate capital. There is a fixed notional amount that allows a trader to place only a specific amount of capital per trade. This style can become ineffective as a trader’s capital grows or falls and can become unrealistic within a very short period of time.
Another style is to have a fixed percentage allocation. The benefit of this style of capital allocation is that it avoids ruin by creating smaller bet sizes as your capital moves lower, but increases and compounds as your capital increases. Since it is very difficult when analyzing a discretionary system to determine if a strategy will have multiple wins or losses in a row, a fixed percentage strategy is a robust style to allocate capital. Another strategy, which is known as pyramiding increases the amount in percentage terms that a trader will risk as the portfolio climbs, and decreases the amount that is allocated as the capital base falls. This strategy works well if the strategy has trends where there are winners that follow winners or losers that follow losers.
The key to a successful money management style is to preserve your capital and live to see another day. “Bet it all strategies” are bound to fail and they should be avoided at all costs. One way to determine the percent to risk on a trade is to determine your goals prior to beginning to trade a strategy. For example, let’s assume a traders goal are to make 10% within a year and he believe that his strategy will generate 10 trades throughout the year, and the strategy generally wins 50% of the time and loses 50% of the time. Also, the strategy usually wins $2 for every 1$ risked. A capital allocation that risks 4% for every 2% risked will generate a return of 10%. (10,000 * 1.04 = 10,400 * .98 = 10,192 * 1.04 = 10,599 * .98 = 10,387 * 1.04 = 10,803 * .98 = 10,587 * 1.04 = 11,010 * .98 = 10,790 * 1.04 = 11,222 * .98 = 10,998) This type of analysis is very important in determining the correct amount of risk to allocate to a trading strategy.
When beginning the process of creating a strategy, regardless of whether the trading strategy is a systematic (automated) strategy or a discretionary strategy it is very important to create a plan on how to manage your capital in a defined way. Sticking to your money management plan is one of the most important concepts and it will make the difference in successful or unsuccessful trading and investing strategy. The underlying fundamental theory with money management is to preserve your capital. More than making money on the markets is the idea that you want to give your strategy a chance to make money by placing numerous trades over a period of time and avoid ruin at all costs. Unfortunately before ruin, there is usually an “uncle point” where a trader decides that the strategy is a failure and he cannot afford to continue. The key for a money management strategy is to avoid both the “uncle point” and ruin. Creating a trading strategy is similar to running a business, you would like it to have a plan, that can be slightly flexible, but you are not willing to lose the business on one client or order.
Once an investor builds a number of positions for either one or multiple trading strategies, it is important to measure the synergies in each position and evaluate whether some positions mitigate the risks of other positions. If an investor has 10 positions and all 10 positions move in tandem, which means they are all highly correlated, then potentially all the positions can move against the investor at one time. This would be equivalent to taking 1 position that would risk ruin. This is a very important concept and a trader needs to perform an analysis to determine if any two or more positions are highly correlated.
Hedging a portfolio
A portfolio of trades can be considered hedged if the different positions are not exposed to directional moves in the market. For example, if a trader had a position where he was speculating on the upward movement of the S&P 500 Index, he would be considered hedged if he had an offsetting position that was betting on a downward movement in the S&P 500 Index or a similar Index. One way investors protect again adverse moves in the market is to purchase or sell options that remove the outright directional risk.
Why would a trader want to do this? Traders often hedge their positions when the risk of a large market move is potentially on the horizon or the trade is close to a take profit level and instead of using a stop loss, the trader uses options to hedge the portfolio. By purchasing put options, a trade can mitigate the directional risk in the market if he owns a long position. Similarly, the trader can buy call positions to mitigate the risk on a short position. There are multiple options strategies that a trader can use to hedge. Some of those include protective puts, covered calls, collars or fences etc… Portfolio management with options is a great technique and a trader should analyze the benefits if he plans to build a portfolio of trades.