Try This Risk Formula In Your Trading

• January 24, 2005
• Steve Primo

Whether you choose to view it as a speeding train,
a worthy opponent, or a raging river, the market is an entity unto itself that
can never be stopped, controlled, or restrained. It is going to do whatever it
wants to do, regardless of what we say, think or especially feel. Our only
resort is to give up our desire to fight or control and simply go with it. The
sooner you come to this realization, the easier your trading will become.

But
in trading there is one thing and only one thing you can control, and that is
your risk. To reiterate — even with a disciplined plan in place, you
still can’t predetermine how high or how low the market will go. You can’t even
predetermine how much of a profit you’ll make should you be right. The only
thing we can predetermine or choose in advance is our risk per each
trade/investment. When we choose in advance where to cut our losses, we are
limiting and therefore controlling our risk.

There are a number of valid ways in which to determine proper risk and stop
placement but today I’d like to speak to you about a method that uses your
system’s worst-case drawdown to decide your risk management. Lets say you’ve
performed 10 years worth of research on your new e-mini S&P strategy and the
profit numbers are quite impressive. Yet what we really need to know at this
point is the value of your systems’ worse slump or drawdown. Let’s assume your
worst-case drawdown for the 10-year period was a series of losses that totaled
30 points on the e-mini S&P. With each point on the e-mini equaling $50, that
represents a -$1500 loss per contract traded (30 x —50= -1500).

Now
let’s assume that you have an account size of $50,000. What we want to do is
decide on a percentage of your account that you would feel “comfortable”
risking, should your system happen to produce another worst-case scenario of -30
points in the future. If you decide to risk 10% of your capital, you are
theoretically saying that should my system go into another -30-point slump, I
will only lose $5000, or 10% of my account. Now divide that figure by the total
dollar loss amount (-$1500) and you arrive at 3.333. This number, rounded off to
3, is the number of contracts you can trade on your new system without getting
yourself into any serious damage. This formula can be applied to equity trading
as well.

Now
I know that most of you are familiar with the concept of only risking between
2-5% per trade, but that amount is derived from a percentage of your “working
capital.” What we are doing in this example is deciding our risk as derived from
our worst-case drawdown. Do you see the difference? To further clarify, let’s
say you decided to risk the standard 3%–roughly $1500–of your working capital
per trade. That sounds conservative, but if it took you a series of 20 losing
trades to complete your worst-case drawdown, in the end that would represent a
loss of nearly -$30,000! A far cry from your loss of only -$5000 when you based
your risk off of your drawdown and not your capital. 

This
ability to control risk is of tremendous benefit because proper knowledge and
use of risk management will ultimately yield much better trading results than
focusing primarily on profits, which is the mistake most beginning
trader/investors often make. In future articles I will discuss many different
ways in which to minimize your risk…the only thing in the markets you can
control. Good luck and good trading.

Steven Primo   

stevep@tradingmarkets.com

P.S. Join me for an intense 14-week swing trading program in which I’ll cover
six statistically-backed systems.

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