Welcome Readers,
The focus of today’s post will be on the most important topic you can ever consider in your trading plan. In fact, it is more important than any chart tool, technical indicator, or price projection method. Today’s post is on risk management. This is one of two reasons most new traders fail (with the second being poor emotional control). Want to know why you blew up your account and sent your emotions reeling off a cliff? My bet would be that you were likely not managing your risk appropriately.
I want to begin today by summarizing an anecdotal story that
can be found in one of Connie Brown’s books, “All About Technical Analysis”.
The story is called the $27 million dollar lunch. The abridged version goes
like this. During one trading day in the Summer of 1991, a notoriously
confident bond trader decided to place a trade using his personal account. He
was well-known to do this, but there are three details that make this trade unique.
First, he opened the trade at double his normal size. No biggie, right? After
all you have to spend money to make money as they say. Second, he told the
clerk at the desk managing his trade that he wanted his position to be doubled
every time the market moved two ticks against him. That’s right,
against. He was employing a Martingale strategy on what could turn out to be a
highly volatile market given the economic conditions at the time surrounding
the gulf war recission. His third mistake, and perhaps, the biggest mistake of them
all though? He didn’t put a single stop on his trade. He did not believe the
market could trade so far against him that he would be blown out of his position.
Boy, he was in for a rude awakening…. So, before we continue with the story let’s
recap what happened. Our trader was willing to employ an extremely risky strategy
with no stops on a potentially volatile market. Got it? Good.
So what happened? Well, our trader left to take a well-deserved 90-minute lunch break. Meanwhile, the federal reserve chose that exact day and time to intervene in the markets. It was not a large change, only a 25 basis point change in the federal funds rate against the direction of his trade. However, this move sent immediate shockwaves through the market and by the time our bond trader returned from his lunch break, the front desk had been notified that his personal trading account had insufficient funds to cover the losses from this trade. The amount he owed? Just a small $27 million dollars. What’s worse, the entire trading firm had to close all of their open positions and their accounts were frozen. The very next day, creditors were on-site to strip the entire penthouse suite that served as his personal trading room of every asset that wasn’t nailed down to cover his losses. It is a complete riches to rags story.
So, what’s the lesson here? The only thing that will allow you to survive the bloodbath that is the markets long enough to learn how to successfully trade and become consistently profitable is a proven risk management plan. Even once you have the skillset and confidence to remain consistently profitable (something I am still work on myself), a risk management plan will be essential to keeping your emotions and ego in check at all times, allowing you to survive through drawdowns and persevere to new equity highs. Therefore, for today’s discussion we are going to start by creating our own risk management spreadsheet as a google sheet or excel file.
This is going to be a relatively simple example because I only need a rudimentary calculator that can tell me know many futures contracts I can open in a position while adhering to a simple risk management rule. The rule itself is simple…I am only going to risk a maximum of 3% of my trading account on any given trade. That’s it. No more. Why only 3%? It’s simple, I know from my own past experience that 3% of my account is the maximum amount of capital I am willing to risk on a trade while remaining emotionless. That’s the key – emotionless. I want to enter a position and not care if the market turns against me. If I were to take on a larger amount of risk I will start to make poor judgement calls. I may think my losses too great and cut the trade off early instead of letting the trade take the time it needs to develop. In addition, if I were to witness a large drawdown on my account during the course of the trade, I may exit my position too soon, cutting off my winners early being happy that I was able to make it back above break-even and leave with a small profit, only to watch as price takes off in what could have been a very profitable position. Believe me, I learned this the hard way watching my account lose 30% once in a single day. Thankfully, this strategy has helped me return to my initial balance. So, for my own sanity, we are going to risk only 3% or less. No more. Okay, now on to building our calculator.
Before we begin, we need to know the internals of whatever
financial instrument we are trading. Since I am currently working on an
analysis of the Russell 2000 futures (RTY), I’ll be using that as an example.
As I stated in my introductory post, I only have $10,000 that I am willing to
risk on futures trades. So, instead of trading the regular RTY contracts, I am going
to trade the micro contract (M2K). This will allow me to make sure that I maintain
the margin requirements necessary to open at least 4-6 contracts if my risk
management plan allows me to. Next, we need to make sure we understand how the
contract is structured. The micro M2K contract is one-tenth the size of the regular
RTY contract. However, the contract still measures the value of the underlying
asset the same way, all that changes is the relative value of the contract for
a given number of ticks. For example, both M2K and RTY move in $0.10 sized
ticks. For the RTY contract, each tick or $0.10 move changes represents a
change in my profit or loss (P/L) of $5. Since M2K is one-tenth the size of
RTY, a $0.10 move in M2K only represents a P/L change of only $0.50.
There is one note I want to make about trading micro futures
contracts before we move on. Since the size of most micro futures is between
one-fifth and one-tenth the size of the regular contract, make sure you
understand how many ticks price must move for you to break-even on your
position considering commissions and fees. In our discussion of RTY and M2K
above, if your total round-trip commissions and fees is $4 per contract, RTY
only needs to move a single tick (or $0.10) in your favor to break even on your
position. However, M2K will need to move at least 8 ticks or $0.80 in your
favor to break even on your position. This is the greatest drawback of micro
contracts (I’d even go as far as to call it a ‘scam’). They are an invaluable
learning tool, but the fees will eat up your account if you are not careful.
Alright, now that we understand the internals of our financial instrument we’re trading, let’s start by putting that information into our excel file. I keep a different sheet tab with information for each contract I am interested in trading so that I only need to switch to the appropriate tab when I am ready to run a new calculation (I prefer to link all of the information regarding my account balance between each sheet so I only need to update the number on the main sheet). An example of how I have set up one my spreadsheet pages with this information is shown below.
Next, we want to provide some quick reference information about our trading account size, the maximum risk we are willing to take on for a single trade as a percentage of our total account, and how much this risk percentage is in dollars. When you win or lose a trade, you’ll need to update the account size to match your new net liquidity amount. We’re sizing each trade based on the total amount of capital in our account at the time of the trade.
Okay, from here we need to stop and actually think about the
trade we are about to enter. There are three crucial things that go into your
plan for every single trade. These are just as important as any entry signal you
will find on a chart. These are your entry level, your exit level, and your
stop loss level. If you have not thought about these three exact things, you
should not even consider entering a trade because you have no idea where to get
in, where to get out, and at what price level do you know you were wrong about
the market. For the potential trade I am eyeing in RTY I have pre-defined these
levels for this week’s upcoming trading sessions. This is not investment or
trading advice.
In addition, there is no guarantee that I will enter a trade
when price trades to the levels I am about define. Ultimately, the only reason for
me to enter a trade when price reaches my entry level is because the
combination of price action, technical indicators, and Elliott Wave analysis tells
me that the current counter-trend move is complete, and the larger underlying
trend is about to resume. However, the entry, stop, and exit information needs
to be catalogued in our calculator ahead of time so we are ready when price
enters our target price zone as it may only stay there momentarily. These values
have been entered into the spreadsheet in the image below.
We will talk about defining support or resistance levels in my next post. However, for now it is enough to simply have the prices. I am expecting near-term resistance in RTY/M2K to come in at Friday’s pre-market high of 2070. However, based on Elliott Wave analysis, I believe there is more to this correction. As a result, the next level of overhead resistance comes in at 2084-2086. There is a final resistance zone just above that level at 2095-2096. My expectation is for price to challenge near-term resistance at 2070. If it cannot overcome resistance at 2070 we will likely see a decline in RTY early into next week which may lead to lower lows. However, the corrective move will have a more complete Elliott Wave structure and proportions if it can instead breach 2070 and target the next overhead zone at 2084-2086. Therefore, my expected entry level is 2084, the very beginning of this target zone. Where does my stop loss go? Right beyond the next resistance zone of 2095-2096. It is not uncommon to see price trade above a resistance level briefly within a 15-minute or 20-minute bar and then close beneath the resistance zone. Therefore, the correct stop placement is just outside of the next resistance zone overhead. I chose 2097 because price often gravitates to nice round even numbers (although in this case 3001 may be the more conservative stop).
So, now we have defined our entry and stop loss levels.
Where does our price target come in at? You’ll see how I determine price
targets in the next post I make, but for now just know that if price is
rejected from the zone at 2084, then I expect price to fall to at least the
2055-2054 level. Therefore, I’ll make that my initial exit level. There, now I’ve
defined my three critical levels, my entry, my exit, and my stop loss. If I
enter this trade (again, remember that I will only take this trade if I have
the proper signals when price is in the zone), then I am risking $65 on each
contract with the potential to make $150 per contract. That’s a risk/reward
ratio (or more appropriately it’s a reward/risk ratio) of 2.3 to 1. My ideal R/R
ratio would be 3 to 1, but I will take any trade that is 2 to 1 or greater. Therefore,
this satisfies another rule for my risk management plan, only take trades where
you will make at least twice as much as you could lose.
Finally, we need to determine how many contracts we can afford to open if we decide to take a position in the price zone based on our 3% rule. To determine that, we need to re-examine the spread between our entry and stop loss levels. The spread between my entry and my stop loss is 130 ticks. For a single M2K contract, that provides a potential loss of $65 (remember, each tick is $0.50). If I only want to risk a maximum of 3% of my account ($300 for an account size of $10,000), then I can only trade a maximum of 4 contracts ($300/$65 = ~4.65). While we could round up and risk a little more to squeeze in a fifth contract, we are going to commit here and now to only risking 3% or less of our account. No more… So, I’ll use the =ROUNDDOWN function in excel to make sure that the decimal is always rounded down to the lowest whole number of contracts. That will also provide us with some wiggle room when it comes to slippage on our market buy orders. We can add this calculation to the bottom of the sheet as shown below.
As a bonus, I can provide you with an added example using the
near-term resistance of 2070. In this case, my stop placement would go just beyond
the resistance zone at 2086 (we’ll use 2089). In this example, the spread
between my entry and stop loss would be 190 ticks (or $95 per contract). To
follow the 3% rule, I could only open a position with 3 contracts instead of 4.
So pay attention to the spread between your entry and stop…it matters!
Until next time, good luck and happy trading…
Best,
DW
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