Risk Management VII

BarroMetrics Views: Risk Management V

Turning today to Manish’s question on leverage and Paul’s question on ‘stops’ and ‘buy and hold’.

On leverage, I view it as a matter for individual preference, assuming we are speaking about competent traders. For newbies, the advantage of ‘no leverage’ is it limits your losses to the amount invested; leverage raises the potential loss to all you have and more.

In the hands of a competent trader, leverage allows you to trade above your weight class. Moreover, in today’s world, leverage allows a competent trader to trade with a relatively small amount of capital, provided the authorities have not made this impossible. For example, in the US, trading CFDs is not permitted by law; in Singapore, margins on CFDs are expected to be raised to 25% of the notional value of a contract – thus effectively killing the non-institutional CFD business (the proposed legislation makes exceptions for institutions, accredited and experts).

When I started trading I had no choice but to trade the full futures contracts: I traded Gold and the S&P. With the knowledge I have now have, it is evident that, given the size of the account, I was overtrading by the proverbial country mile. Yet today, with US$5000.00, I can trade 5 S&P CFDs.

The reason why lies in the size of the contract. The S&P e-mini futures is US$250.00 per point (1871 to 1872 means you made US$250.00), while the CFD contract is US$1.00 per point. Using the same money management rules, that allow me to trade 5 S&P CFDs, I would need US$250,000.00 to trade 1 S&P mini futures.

So, what do I look at to manage my leverage? I look at:

  • The probability of consecutive losses given my trading track record. I want to keep the potential loss at 50% of my long-term average profitability. And,
  • The maximum total portfolio risk at any given time: no more than 40% of my long-term average profitability.

Turning to Paul’s questions (see attachment):

1. Just like your mentor Peter traded without stop-loss, my basic question is
“Can we make consistent profits without using stop-loss?”

This depends on whether you predefine your exit conditions, and on your  ability to execute the exit plan in face of losses, especially larger than expected losses.

Peter took the view that exiting a trade depended on whether or not a market accepted beyond key reference level.

Let’s say, for example,  I am short the S&P at 1843. My key resistance is 1867; acceptance above 1867 would mean I am wrong about the trend being down. Now. there is a world of difference between prices going above 1867 and then selling off (i.e. rejection the probe above 1867), and prices going above1867 and moving higher (accepting above 1867). In the case of rejection,  we may look to exit at better prices, or may look to stay in trade; in the case of acceptance, we look to exit, and usually exit immediately.

When we place a hard stop above 1867. we have no way of telling whether the fill will denote rejection or acceptance.  So, why do I advocate a hard stop for newbies?

There is a trade-off if we use an acceptance exit strategy. One the positive side, for example, rejection means we avoid being stopped out, only to see the market move in our favour; on the negative side, exiting on acceptance above 1867 means we will see a worse exit price than our hard stop level.

The key to this exit strategy is to be able to ruthlessly execute; and this comment explains why I advocate newbies use a hard stop: in my experience, few newbies have the necessary discipline to exit once there is acceptance beyond a key level

More tomorrow.


4 thoughts on “Risk Management VII”

  1. hi Ray,
    To trade like Peter, the traders have to have very high accuracies of
    1. Determining the key reference points – KRPs (as taught in HOS)?

    2. Judgement of rejection or acceptance of that KRP?
    – could be difficult for newbies



  2. hi Ray,
    1. Did Peter has a maximum loss allowed in mind when he traded without stop-loss?

    2. What position sizing strategy you will recommend to trade like Peter?


  3. Hi Paul

    1) No idea. I can tell you only what he taught. He never mentioned ‘max stop losses’.

    2) Position sizing is very personal. I have given you some ideas in this series on how to assess max given your expectancy return, anticipated consecutive max loss, and average return on capital.

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