Chapter 14. Using and Controlling Risk to Your Advantage

“How much are you willing to lose on this trade?”

Risk is a buzzword within the financial world that can lead to a multitude of conversations. Commonly, your risk tolerance is how much stock exposure you should have at all times. This is an interpretation laughed at by every successful trader I know. The idea that you should always have stock exposure and the level should equate with your age or time horizon assumes that you have no ability to know when to move in or out of the market. I would take this a step further to say that adopting this definition of risk assumes that market timing isn’t even possible. If that is the case, I guess it is just a matter of time before the hundreds of successful traders I know, making consistent gains day in and day out to feed their families, go belly up. Sorry to all of my trading friends out there; it’s been fun.

The other common theme related to risk is its relationship with reward. We’ve all heard the general idea that if you take a greater risk, you have the potential for a greater reward. When it comes to trading stocks, I think this is the biggest crock going. If you believe this even remotely, I encourage you to purge this from your brain when approaching a successful trading strategy that seeks to make consistent profits over time. The “more reward for more risk” thesis insinuates that for you to make money trading you have to constantly put yourself in a position of potentially great loss. In reality, nothing is further from the truth. Successful trading is about quantifying and controlling your risk from the beginning to the end of each and every trade you take. It is this understanding of risk that will separate you in terms of longevity within the trading world.

I come across many traders who, despite their best efforts, cannot remove the gambling philosophy from their trading. Maybe this relates to you. Are you occasionally enticed to buy a stock you see plummeting? Or perhaps you’re tempted to short a stock you believe simply cannot go any higher? How about taking a chance on an earnings report or an FDA announcement within the biotech world? The allure of rapid riches entices many. However, absolutely nothing good can come from acting on these temptations. Although financial calamity is possible, the biggest danger in venturing away from your disciplined trading strategy is actually the potential for success in the trade.

Suppose, for instance, that you witness a stock falling sharply to depths you never thought possible. So, you ask yourself, “What’s the harm in taking a few shares at these levels?” With no set strategy, rather more like a crap shot, you take a few shares. Your timing couldn’t have been better, and within moments the stock reverses and your gamble pays off. You might believe this is the mark of a great trader when actually it is the start of your gradual demise. Not only does the money flow in from the trade, but others congratulate you as if you had some innate knowledge of what would happen. The combination of an increased financial position and superficial confidence is deadly. The next time an opportunity develops that is similar, odds favor you taking the trade again with greater confidence because of the result of the previous bet. It is only a matter of time until the tables turn and the outcome is not favorable at all. You must avoid these major financial and emotional setbacks. The only way to do so is to disregard the notion that says the greater reward comes from the greatest risk. Sustained reward in trading does not come from taking exorbitant risk but in calculating your acceptable risk and utilizing your edge over a large enough sample set of trades.

In short, the two basic principals about risk as discussed in the mainstream are a far cry from how they are discussed in successful trading circles. Furthermore, successful traders have, for the most part, given up on trying to convince the masses of this and have come to the conclusion that time and again most investors will just be led blindly to slaughter by those attempting to educate them about traditional and unrealistic ideas of risk.

If I were to ask you what you would be willing to lose before taking a trade, what would your answer be? Maybe you would chuckle and say zero. While humorous, this is already poor execution, setting you up for consistent frustration and ultimate failure. Whenever you approach any trade, the first variable you must understand and embrace is the amount of money you are willing to lose on the trade. Just as you would write down the reasoning behind the trade—the pattern you have recognized, and where you would be wrong (i.e., your stop)—you should note the amount of money you are willing to lose on the trade if you see the trade through from start to finish. Risk is as simple as that and can be defined as the amount of money you are willing to lose to see whether your pattern-recognition read plays out as you believe it could.

Earlier I discussed a plan that had me entering a plethora of trades. My goal was simple. I wanted to take my proven edge and increase my sample set in the same way a casino expands its gaming floor, thus increasing my rate of return. This did not pan out as I hoped. The end result had me exhausted and frustrated. Rather than increase my profits by increasing my sample set, I learned to increase my returns by gradually increasing the amount I risk on each trade. I find myself trading less while seeking out only the best opportunities, instead of taking them all. It is peaceful, profitable, and most important, scalable.

As a trader, before entering any trade, you should set a fixed dollar amount or portfolio percentage you are willing to lose. For example, I manage a public portfolio tied to a subscription service whereby I send email alerts for every trade I execute. When I launched the portfolio, I allocated $100,000 to begin the account. Within this portfolio, my risk per trade is .5% of the portfolio, or $500. The hedge fund I manage is much larger, and the dollar amounts are significantly increased. Because I’m managing a much larger pool of money here, I am susceptible to liquidity issues and am not as flexible. I have learned that a typical risk of .2% of the portfolio is acceptable for each trade. Finally, my most passive management service, separately managed accounts, possess a much longer time frame, seeking to capitalize on patterns that may take weeks to months to play out. I have found that a risk between .5% and 1% per trade is acceptable.

I encourage you to find an amount based on your trading capital somewhere between .2% and .5%. Regardless of the amount, the importance lies in you knowing exactly what the amount is you are willing to lose before you ever place a trade. Not only is this psychologically important, but as you will soon see, it is the first variable from which we will build our entire trading strategy.

So, what is your risk value? Determining this value might prove a bit tricky. In my opinion, while you are learning and honing your skills, your risk level must be something that is extremely palatable. The key when you are learning and refining your strategy is not to let the risk dictate your trades. Instead, you want to become comfortable embracing the risk on each trade. You must be able to execute your trades without any outside influence, such as worrying about the potential for loss. The risk does not determine the trade, you determine your risk.

I often hear people discussing paper trading as a way to learn trading. While, in theory, learning to trade without having any financial risk makes a great deal of sense, it will not help you. Regardless of what the risk per trade is, an immediate emotional connection attaches to the trade when real money is on the line. Rather than paper trading, when you are learning, I believe it important to just use an extremely low risk per trade, but to at least be financially committed to some degree. At almost all levels, commissions become a factor. However, when you start down this road, do not let the brokerage commissions influence your decision making. Consider these an educational cost; after all, your future benefit will be far greater when you eventually increase your risk per trade.

You might not be in a position to pursue your trading plan with real capital, in which case you are currently at a disadvantage. If there is no other option but to paper trade, you must have a set plan in place, as if it were your actual money. There can be no trades where you believe “such and such will happen” and therefore take 1,000 paper shares on a whim. It is imperative that you practice as if you were trading real money, quantifying your risk per trade, setting your stops, and executing the trade strategy we’ll continue to discuss. Paper trading will never replace the true emotions of having real money on the line, but done properly it will at least allow you to follow a specific strategy and learn the methods you will utilize to become successful.

Take a moment now to ponder what you would be willing to risk on each trade. When in doubt, start with a value that is lower. You can always increase this, and in fact will do so as your confidence and skill set improve. In addition to your risk per trade, spend some time thinking about your total acceptable portfolio risk, assuming you have more than one trade going at any given time. It is not enough to mentally accept the individual trade risk, but you also must accept the total potential loss should you be stopped out of every position you are in. Predetermining this amount will allow you to set a limit to the number of stocks you will hold at the same time.

For those new to this strategy, I recommend starting at .2% with no more than four positions on at a time. If you are trading with $50,000, your risk per trade is $100, with a total of $400 at risk, if you are in fact in all four trades. This should allow you to proceed with trades without an overwhelming fear of great potential losses. If this amount creates anxiety, it is too high and you should reduce it even further. Over time, you should increase this in increments of .1% until you get to a level that is sustainable and sufficient, such as .5%.

It might be easy to sit back and ponder a specific risk value or percentage, but understand that this is an evolving exercise and one that must be continuously reviewed as you grow as a trader. Your ongoing success as a trader will correlate quite a bit with how honest you are with yourself and your inner feelings. It isn’t enough to simply set a risk value, if you don’t truly own that risk value. Owning the risk value means that after the trade is placed, you have emotionally and psychologically accepted the fact that you may very well lose the risk value you have established. Once the trade is placed, if the potential for loss makes you uncomfortable at all, it is an indication that your risk value is too high. If this emotion comes into play, it will soon influence your decision making, and will hinder your growth both emotionally and financially as a trader. It is of extreme importance to establish a specific risk value, implement it, and own it throughout each and every trade. Furthermore, it is important to set a risk value that can be adhered to for a large enough sample set, in my opinion at least 20 trades, without the trader feeling the need to immediately reduce the risk because of a string of losses.

After you have determined your appropriate risk level per trade, and your acceptable total portfolio risk, remain consistent with these risk levels. You may fall into the trap of increasing risk because a specific trade appeals to you more than another. Whenever you increase or decrease your risk levels, it is imperative to remain consistent for at least the next ten trades. Increasing risk on one trade, which may result in a loss, then subsequently reducing risk once this loss occurs, will only increase the number of profitable trades needed to make up the previous loss. An ever-changing risk value will lead to an erratic and ever-changing equity curve for your portfolio. Identify your appropriate risk levels and stick with them.

Controlling Risk

One of the most potentially damaging aspects of trading is when a position or portfolio takes a drawdown that is outside the bounds of a normal drop. This amount may vary for different traders. However, any portfolio draw in excess of 20% will typically inflict emotional and financial wounds that may damage a trader’s confidence to the point of no return. Successful traders rarely if ever allow this to happen, not because they select better stocks or because they have a better handle on market movement, but because they manage risk and understand this is paramount to their ongoing success. At any given time, you should know precisely how much risk you have exposed yourself to and be comfortable with that amount. It is not uncommon for me to review my portfolio risk several times a day, either adjusting stops or cutting share counts, to make sure this risk remains acceptable. Unless you are all cash, it is impossible to eliminate your risk altogether. However, it is quite possible to remain in control of your risk at all times.

Understanding your initial risk value per trade is essential. However, you cannot stop there. You also need to understand what I call your initial and live portfolio risk. This is the total value of losses you would experience if every position you had is stopped out simultaneously. Although it is rare that this would happen, it is helpful to know what you have exposed yourself to, in the event it does. It is this calculation that is essential for you to know at any given point during any given day. I believe that knowing this value has allowed me to continuously achieve new account highs despite minor setbacks through my normal and acceptable portfolio drawdowns.

To calculate this, I commissioned the development of a program called the Risk Analyzer that evolved from a basic spreadsheet. On this spreadsheet, I manually update my current positions, including their current stop loss values and their current prices. Multiplying my share count for each times the difference between the current stock price and stop price gives me my live risk per trade. I then total this live risk per trade to give me my total live portfolio risk. Thankfully, I no longer have to manually input all this data because the program I developed, calculates this information for me. In many instances, I have cut positions or eliminated them altogether if I felt my live portfolio risk was too high. I have outlined a brief example of what this would look like for a mixed portfolio of three stocks, each taken with an approximate risk of $500 (see Table 14.1). In this example, you can assume that each trade has been taken and is still trading within the price from which the trade was executed, thereby showing the initial per trade risk.

Table 14.1 Total Portfolio Risk

Although this is a good start, the markets are continuously in motion. Therefore, your live risk is continuously in flux. To maintain a true understanding of your live risk, the current price column must be updated to reflect the changes in stock movement.

It is not enough to mentally own the initial stock risk, but you must also mentally own the live portfolio risk. In the past, I used to call the unrealized gains in my account house money. I would say things like “playing with houses money” and “the trade is now risk free.” This mindset was not only wrong, but also very dangerous, in that when a reversal set in I was constantly not only giving back the houses money but also taking a draw through the initial risk. In hindsight, I was far too cavalier when I was in trades that were going in my favor. I needed to look at the unrealized gains not as house money but as my money and to count these gains as risk, just as I would the initial risk I had taken on the trade. When I finally embraced this, it changed my trading forever and dramatically increased the speed at which my equity curve rose.

You must understand, embrace, and accept your live portfolio risk when your stocks are moving and changing in price. When trades are going in your favor, your live portfolio risk grows exponentially and becomes much greater than the initial risk should the trade reverse and be stopped out. Most of the time, a trader will not calculate this risk for unrealized gains. However, I have found that unrealized gains are just as important to understand and embrace. A common pitfall when the market is moving in the direction of your trades is for you to add more positions without updating your live portfolio risk. Initially, these new trades may show you a greater profit. However, I have personally seen great damage done when the market reverses abruptly, not only stopping you out of new positions that never showed a profit but also taking away unrealized gains.

To review this change, let’s assume for a moment that each trade on our previous example advanced in your desired direction 10% and for the time being no new positions were added (see Table 14.2).

Table 14.2 Total Portfolio Risk

You may assume that the live portfolio risk would increase by the same 10% amount, when in reality it more than doubles from a total of $1,500 in our first table to $3,883.08 after the current prices of the stocks are updated. Yes, these are unrealized gains, but this calculation is now the real portfolio risk you face if you were to be stopped out of all positions after they have already moved in your favor 10%. While trades are in existence and moving, this calculation can help you can gain a much better understanding of what you stand to lose in real dollars if your stops are hit. If you cannot accept this live risk and do not feel comfortable with this exposure, either the position needs to be reduced or your stops need to be raised. The next chapter addresses this when we delve further into the trading strategy.

I hope, by now, you are looking at risk in a completely different way and realize just how important it is within a successful trading plan. I cannot stress enough how important it is to mentally own the risk from the perspective of each individual trade, but also from the perspective of the entire portfolio. Failure to mentally own this risk will allow emotions to control your trading, and you will fall into the trap of making erratic decisions in the heat of the moment. If you haven’t done so already, think about what you are comfortable with as an acceptable risk per trade amount. Also ponder what you are willing to accept as a live portfolio risk at any given moment. Write these numbers down, keep them by your trading station, and firmly implant them into your brain. Do not view them as negatives but as allies and guardrails for you in your new journey of successful trading.

* The risk analyzer is available at www.tickerville.com.