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Options Theory: The Game of Risk Management

January 28, 2019

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The kamikaze trader

Let’s play a game. A risk management game. We’re going to take a random person off the street and give them a $25k account to trade. Then we’ll train them on the basics. In fact, since we’re kind chaps in search of good karma, we’ll give them unfettered access to every training offered here at Tackle Trading.

Now, here’s the contest. You are tasked with crafting the risk protocols that this budding investor must use. The aim is to ensure their survival, to make it extremely hard (impossible would be best) for them to blow up the portfolio.

What kind of rules would you use?

In running through this exercise with thousands of traders I’ve discovered what I think is the key to the quest. You have to start with the right premise. And this is it:

Assume you are a moron, devoid of any skill, hellbent on blowing up your account. You are a kamikaze trader.

If you can craft a set of rules to protect this hypothetical trader (that in no way reflects any of your inherent good looks and sheer genius), then you are guaranteed to protect yourself from ruin.

Here are my top four guidelines.

Equal and Small Risk per Trade

To insulate Mr. Kamikaze from randomness’s wily ways, I will mandate that he risk the same amount in every trade. That way it won’t matter which trades he wins and which he loses.

Next I’ll require him to risk 1% of the portfolio (or less!) in each trade. For a $25K account that comes out to $250. This improves his ability to withstand the inevitable losing streaks that will come his way.

Time Diversification

The next rule speaks to spreading out our exposure to market risk and allowing each trade to behave more independently. He has to stagger his entry into new trades over time. Suppose he places ten trades a month. They have to be spaced out to approximately one new entry every other trading session.

That way one big buying or selling wave in the market won’t wipe out too many trades simultaneously.

Ask any seasoned trader when they’ve experienced the most gut-wrenching losses. My bet is it was when they had too many similar positions move adversely at once. Time diversification will protect against such an outcome. But so too will the next rule.

Strategy Diversification

If we assume our plucked-off-the-street trader lacks any forecasting prowess, then we want to avoid him carrying too many like trades simultaneously. No, he can’t hold 10 bull trades at once. Nor can he hold 10 bear ones. He’s got to switch it up!

By rotating strategies he will be able to keep his trade quantity up (which will help reach the average result quicker), but won’t be exposing himself too much in the process. The devil’s in the details on this guideline, but the gist of it is that he has to frequently switch up his strategies.

Here’s what I don’t want to see over a 5-day period: bull trade, bull trade, bull trade, bull trade, bull trade.

Here’s what I do want to see: bull trade, neutral trade, bull trade, bear trade, bull trade.

If his portfolio consists of a potpourri of positions then the odds of getting hit on everything at once is virtually nil.

Loss Limits

My final rule involves setting a loss limit that he can’t exceed in any given month. It has to be an amount that allows him some flexibility to experience the occasional losing streak. But it can’t be so large that he’s able to dig a hole that takes eight months to claw his way out of.

Ideally, I want him to recoup a bad month in the next three to four months.

If he’s risking 1% per trade then I’ll set the monthly loss cap at around 10%. That should be plenty of rope, but not enough to hang himself.

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