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Some specifics about risk: Although there is a great deal written about how to pick stocks, I have found relatively little of value on how to minimize the risks that are inherent in trading.  This is critically important, because “… to whatever degree you haven’t accepted the risk, this is the same degree to which you will avoid the risk. Trying to avoid something that is unavoidable will have disastrous effects on your ability to trade successfully.  Learning to accept risk is the most important skill you can learn (1).”  Risk really needs to be considered before you even think about selection criteria, and before contemplating any purchase.

There is important evidence that shows that one should never risk more than 1 or 2% of one’s total equity on any one trade, and that to do so invites ruin. In every market, in spite of the best homework, there are still periods in which there are many losses (dozens!) in a row.  This happened many times in the bear market, from March of 2000 to date.  It also happened many times in the 90’s bull market.  But imagine that one has a system that is right 55% of the time.  I don’t know of a single one, although super traders do sometimes reach that level (2), and the criteria that I follow also accomplish this for periods of time (3).  If you put all of your money on such a system once, you still have a 45% chance of being wiped out. If you risk all on such a system repeatedly, your chance of ruin reaches 99.99%. On the other hand, based on the same system, if you only use 10% of your money per trade, your ultimate chance of success reaches 81.8% (4).  Or, imagine a “system” in which you are wrong 55% of the time (This one sounds familiar).  When you’re wrong, you limit your loss to 2%, but when you’re right, you make 6%, 10%, or far more.  Your profit to loss ratio (5) will systematically lead to growth of your equity in up markets, and will minimize the damage in down markets.  The long-term result will be a gain.  You would have to be wrong 50 times in a row at 2% per loss, to be wiped out. If you stop and think about it, it’s as hard to be wrong over half the time, as it is to be right over half the time.  As hard as it is to believe, the market really doesn’t know or care that it’s you.

Risk is a two edged sword.  If you risk 2% of your total equity on every trade, an unusual series of losses could still lead to a fairly large drawdown.  Research by Van Tharp (6) and others has shown the obvious, that although a higher degree of risk may lead to significantly greater gains, it also is likely to lead to bigger drawdowns and a greater chance of getting wiped out. In his studies, he evaluated trading on risk levels from 0.1 % (one tenth of one percent) all the way up to 7.5%.  This is another way of saying that trades were exited if losses reached 0.1% to 7.5%.  Trading simulations risking more than 2% were found to be gutsy. At 2.5%, the worst drawdown reached 86%.  He refers to those who assume risks as high as 3% as “gunslingers.”  Basically, strategies that assume risks much over 2% represent a death wish (because they eventually lead to getting wiped out). The chart below illustrates the importance of Rule One. 

It’s derived from a series of my own trades, but has been modified so that the size and number of losses exactly equal the size and number of profits.  Assume that you have a $100,000 account to start with. The top half of the chart represents 50 breakeven or profitable trades, net of all commissions, ranging up to $10,000. Total net profitable trades = $118,924. The bottom half represents 50 losing trades, in reverse, from the largest loss of $10,000, on up to 0. Total net losses equal minus $118,924. If you had taken all of these trades, your profits and losses would have canceled each other out, for a net profit or loss of zero.

If, instead, you had just limited your losses on the worst 26 trades, by exiting them when they reached 2% of your total equity, you would have been left with a net gain of $41,819.  If you had cut your losses on the worst 37 trades, as soon as they reached 1% of your total equity, you would have had a net profit of $73,686. This only illustrates the advantage of limiting your losses. What about the disadvantage of cutting your profits short?  If you had cut your profits short on just your best 26 trades, when they reached $2000, you would have ended up with a net loss of $41,819!  If you had exited your best 37 trades when they reached $1000, you would have a net loss of $73,686. A further note: it might have occurred to you that many profitable trades first dip into the red before taking off. That’s absolutely correct. So if you exit every trade at a given percentage of loss, no matter where you draw the line, you will miss out on some trades that subsequently become profitable. Nevertheless, the principle of limiting losses and letting losses run is rock solid, in the aggregate. The details are summarized in the table below: 

$100,000 account.  100 trades, 50 profitable and 50 equally unprofitable:

Arranged from largest loss ($10,000) to largest profit ($10,000)

Net P/L

#1: If you had taken all 100 trades:

Profits

 $ 118,924

With maximum loss on all 50 losing trades

Losses

 $(118,924)

Net P/L

 $            -

#2: Limit losses to 2% (2% of $100,000 = $2000) of total equity

Profits

 $ 118,924

Limit loss on worst 26 trades to $2000 each

Losses

 $  (77,105)

Net P/L

 $   41,819

#3: Limit losses to 1% (1% of $100,000 = $1000) of total equity

Profits

 $ 118,924

Limit loss on worst 37 trades to $1000 each

Losses

 $  (45,238)

Net P/L

 $   73,686

#4: If you had limited profit on best 26 trades to $2000 each

Profits

 $   77,105

With maximum loss on all 50 losing trades

Losses

 $(118,924)

Net P/L

 $  (41,819)

#5: If you had limited profit on best 37 trades to $1000 each

Profits

 $   45,238

With maximum loss on all 50 losing trades

Losses

 $(118,924)

Net P/L

 $  (73,686)

I can’t stress this strongly enough. You must limit your losses and let your profits run on 100% of your trades. It’s OK to be just an average stock picker, or for that matter, one of the worst. You can base your trades on nothing but hype, or you can base your trades on the best fundamental and technical indicators. You can make one dumb mistake after another in the market, but if you systematically ignore the importance of limiting your losses and letting your profits run, you will steadily but surely wipe yourself out. Whether you are a short term trader or a long term investor, unless you establish Rule One as your foundation for a solid trading program, the best stock picking in the world won’t save you. In the above exercise, you could draw the line on losses at an infinite number of places, but provided you draw it outside the noise range (discussed later), your bottom line will improve.  The same goes for letting profits run. There are many ways to detect the end of a move. If you apply any of these methods, staying with good trades as they become more and more profitable, again, your bottom line will improve.

Assuming that you are completely committed to Rule One, there’s still much else to deal with, such as diversification, your selection criteria, position sizing, and monitoring your positions.

Coming up next, Risk Control: Diversification

Notes:

1) Douglas, Mark, Trading in the Zone, New York Institute of Finance, 2000, p. 10.

2) Kiev, Ari, Trading in the Zone: Maximizing Performance with Focus and Discipline, N.Y., Wiley & Sons, 2001, pp. 106 and 128.

3) For instance, from March to August, 2003, 70% of my 123 trades were profitable.  For the entire year’s 333 trades, however, only 48% were profitable.

4) Teweles, Richard J, Charles V Harlow, and Herbert L Stone, The Commodity Futures Game: Who Wins? Who Loses? Why?, McGraw-Hill, NY, 1974, p 263.

5) P/L ratio = the sum of all your profits (in dollars) divided by the sum of all your losses.

6) Tharp, Van K, Trade Your Way to Financial Freedom, McGraw-Hill, NY, 1999, pp 292-294.

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