Tuesday, September 5th, 2006
Creating a trading risk management plan, part II
Last week we looked at how thinking appropriately about risk is the basis of a successful risk/money management system. Basically we should recognize that unexpected things do happen and that we can’t predict the future.
The next step is to work out the objectives for your trading or investing. Do you want big returns with big drawdowns? (A drawdown is any fall below a high point reached in your account. If it was worth $10,000 yesterday and $9,000 today, you’ve suffered a 10 per cent drawdown). Or do you want to limit volatility and knock out steady returns?
The answer to this question will determine how you deal with key issues such as how much you should risk on each trade, how much of your total account should be at risk at any one time, and how diversified your holdings will be. You should spend a lot of time reflecting on this. Maybe go to a coffee shop or take half a day off from work and family commitments to ponder just what you want from trading in terms of returns and volatility.
WHAT RETURNS DO YOU WANT?
The first thing is to set your annual return target. From my own perspective, being reasonably young and without children, I want to be quite aggressive and maximize returns. Ideally I’d like returns of more than 20 per cent compound per annum. With the size of my account and the risk I’m willing to take on, that shouldn’t be impossible.
HOW MUCH ARE YOU PREPARED TO RISK?
As everyone knows, there is no reward without any risk. As a general rule the higher the returns you want, the bigger the drawdown your account will experience over time. Of course some shorter-term and options traders will be able to generate huge returns with little drawdown. But they often face risks from shock events that wipe out their accounts after years of steady increases. So it is safe to assume that the bigger the returns you want, the more volatility your account will experience.
An appropriate exercise now is to work out the absolute maximum drawdown you can tolerate. My own tolerance is for my account to fall as much as 35 per cent at the most. I think it is easy to overestimate the volatility we can actually handle. Assume you have a $100,000 account: do you really think you could stand seeing it drop to $90,000, then $80,000, then $70,000? Could you watch $30,000 disappear because it’s a normal drawdown for the risk management strategy you’ve planned?
Some may find as we continue in this series that their return and maximum drawdown figures simply don’t match. For example, if you think you can only suffer a 5 per cent drawdown but want to earn 50 per cent a year, you may find that this is totally incompatible.
Now we have an appropriate mindset, and ew’ve established a rough estimate of what we want to make and how much we are willing to risk to get that. Next week we’ll look at how much of your total account you should risk to achieve your objectives.
Word Count: 508. This entry was posted on Tuesday, September 5th, 2006 at 9:09 pm and is filed under Risk management. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
