Professional traders, especially those who advise retail traders, fall short when it comes to risk management. They discuss the topic in much the same manner as priapic teenagers treat the concept of foreplay: They have heard through friends that it's a good thing but they just want to get to the main event.
Added to the confusion, in the effort to gain street cred, everyone talks about how they nailed this trade or that trade. Wrap everyone in a damp towel and it'll look and sound just like a high school locker room.
To be sure, traders who ignore the foreplay of risk management will get lucky with their trades occasionally. But far more often the result is a trade that is a loud slap across the face. The real tests come in stagnant and soul-destroying bear markets.
A trader without consistency in risk management, is going to become frustrated in a stagnant market and begin to make trades out of desperation. In a bear market, things get even worse for a retail trader. He's achieved success under more favorable conditions with whatever trading system he's adopted and begun smoking his own dope if he clings to the idea that it can never fail.
Why does he cling to this idea? Because the guys in the locker room told him so. He doesn't notice that the talk in the locker room is more subdued in range-bound and weak markets. We saw it in 2000 with the demise of the amateur day trader. We saw it in 2008 with the implosion of many "professional" funds that outsourced their due diligence to ratings agencies. We will see it again, whether in 2016 or not. The bottom line is that those without any game will get kicked out of the game, often never to return.
If we admit, even privately, that as an industry we're perpetuating a problem by not talking about risk management, how do we make things right?
As professionals, traders need to do the socially and morally right thing and weave risk management into every aspect of the advice we give to retail traders. It's the right thing socially because it is in everyone's best interests for retail traders to understand the tools necessary for success. Morally, it's the right thing to do because trusting people are putting faith, and capital, at risk following what we as an industry say; we can't abuse that trust.
To be effective, risk management has to be exercised simultaneously at three levels: on a per position basis, in portfolio construction, and in portfolio management. While it is the most important aspect of any trading system, it is a three-legged stool, prone to failing if you neglect even a single leg.
Risk Per Position
Risk per position is the building block of any type of systematic risk management program. In reality, this is the only thing you have control over. You have no control over the reaction to earnings or news, you have no control an institutional seller liquidating a position, you have no control over the market taking a 3% dive in a day. The only thing you can control is what you're willing to risk on that single position.
With options, this is easy to control: the max risk of your position is your margin impact. For people who don't know how to use options and are trading equities only, the only way to control the risk is to use stops. Not mental stops, not price alerts, but actual conditional orders that get sent to the exchange to liquidate your position if it breaks through what you're willing to risk in that position.
The amount you risk in one position must be a consistent percentage across all positions. It also has to fit with your personality.
Trading is as much psychology as it is analysis and mechanics. Take on too little risk, and you'll begin to loosen stops and violate rules. Take on too much risk and you'll constantly be watching positions, poking them, sweating them, and then liquidating them for small gains.
If the amount you are risking per trade is not consistent across your portfolio, you are handicapping your trades like a bookie handicaps a horse. You need to be consistent in your per position risk. Nobody puts a trade on with the intent that it will lose money, but it's all a game of probability until the trade is done. When you handicap your trades, you are not systematizing your risk, you are essentially gambling on gut instinct.
Portfolio construction is the next stage in risk management. Most retail traders tend to be all bullish (or less often, all bearish), have relatively few positions, and are fully allocated in their portfolios. They are willingly putting themselves in the position where they must be right in order to be profitable.
Broad market and sector analysis will tell you how bullish or bearish your portfolio should be as well as where to be bullish or bearish. You should never be 100% bullish or 100% bearish in a portfolio; it eliminates your ability to withstand volatility. You should be long the strongest stocks in the strongest sectors and short the weakest stocks in the weakest sectors. Don't try to call the top or the bottom. Stay with the trend until the trend tells you otherwise.
Additionally, you should never be 100% allocated in your portfolio. Being completely allocated removes your ability to react to changing market conditions. If you have a significant cash position and the market shifts, you can rapidly reinforce success in the types of trades that are working for you, or have the ability to hedge out your entire portfolio to buy you the time and flexibility you need to manage positions.
Portfolio construction leads directly into portfolio management. As a trader, your portfolio is dynamic. Trades will hit profit targets and be liquidated. Trades will be stopped out for the small loss. New trades will present themselves. Market conditions will change. Sector rotation will occur. All these events require you to actively manage your portfolio.
There will be times where, through whatever mechanism (stops, profit taking, option expiration), that you find your portfolio out of balance with what your broad market and sector analyses say it should be. More than once I have found myself uncomfortably bullish or bearish after an Expiration Friday. In those situations, I am compelled to only place trades that will bring my portfolio back in line with my view of the broad markets before I look for additional trades. It is annoying at times to do this, but I am able to sleep at night knowing that my portfolio can weather volatility.
The subconscious has a wonderful early warning system -- use it. If you go to bed at night thinking about a particular position, that position is too large and needs to be reduced or liquidated the next day. Likewise, if you go to sleep thinking about how much of your portfolio is at risk, it is too much and you need to start methodically reducing your risk, even to the extent of hedging your entire portfolio until you've gotten your positions back in line.
Without applying consistent risk management first, foremost, and always, even the very best trading system with all the bells, whistles, flashing lights and trade alerts will suffer. It is actually likely that you will lose money over the long run.
Conversely, even a marginal trading system coupled with stringent risk management will produce gains and allow traders to survive market volatility.
Marrying systemic risk management with a time-tested trading methodology is the best way to chart the course to financial freedom.
Apply risk management logically and consistently -- invest time and effort into trading foreplay. You'll weather whatever the market throws at you. Never put yourself in a position where you
encounter a catastrophic loss that knocks you out of the game. Sometimes in this arena, the only thing you can ask for is survival, but that will keep you in the game to trade another day.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.