Risk Management in Trading as explained by Peter L Brant

 

Successful trading operations are dictated primarily by how risk is managed. Many novice commodity traders assume each trade will be a winner. Professional traders manage their trading to assume that each trade may be a loser. Obviously, there is a major difference between the two perspectives. The Factor Trading Plan operates with several global assumptions, including:

I have no idea where any given market is headed. I may think I know, but in reality I do not know. History has shown that my degree of certainty about a given market’s direction is inversely correlated with what actually happens. In fact, I think a trader with excellent money management practices could take the other side of trades in which I have a strong belief and make money consistently.

 About 60-70 percent of my trades over an extended period of time will be profitable.

As many as 30-40 percent of my trades over shorter periods of time will be unprofitable.

 There is a high probability each year that I will incur eight or more losing trades in a row.

 There will be losing weeks, losing months, and even losing years in my trading operations.

 Important risk management guidelines have been incorporated into the Factor Trading Plan to address these global assumptions. The primary guideline is that the risk on any given trade is limited to 1 percent of trading assets, and preferably closer to half of 1 percent of assets. Because I think in incremental units of $100,000, this means that my risk per trade per unit of $100,000 is a maximum of $1,000. My trading assets committed to margin requirements rarely exceed 15 percent. I don’t recall ever receiving a margin call for the account used to trade my full program. If  I risk 1 percent of assets per trade and am wrong eight straight trades at least once each year, it means that I will experience a drawdown of at least 8 percent with certainty, at least on a closed trade basis.

 A 15 percent drawdown is about as much as I can emotionally handle. I have encountered a drawdown of at least 15 percent in 9 out of every 10 years I have operated a fully implemented trading program. I find myself more risk intolerant as I grow older. At the present time, my risk management protocol attempts to limit the maximum annual drawdown to 10 percent (measured from week-ending peak to week-ending valley). I attempt to ignore intraday equity spikes because I have no desire to catch the bottom of each day’s high or low, and I do not want to waste energy in even thinking about it. In  fact, as I will discuss in this book, I think it is unwise to pay attention to account equity levels on a day-to-day basis. I consider correlation between markets when determining risk. For example, a bearish trend by the U.S. dollar against the euro is also likely to be accompanied by U.S. dollar losses against the Swiss franc and British pound. A bull market in soybeans is likely to be accompanied by advances in soybean oil or soybean meal.

In composite positions of highly correlated markets (grains, interest rates, stock indexes, currencies, precious metals, industrial commodities), I attempt to limit my risk to 2 percent of assets. All successful trading operations must be built on a foundation of overall risk management.