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Jun 13

The Problem With Cutting Risk

Categories:

Risk Management, Trading Psychology, Uncategorized

by Rogue Traderette

It surprises me how quickly after a few losses my whole psychology has the potential to turn to smoosh.   I stop and listen to myself think, sometimes, and have no choice but to come to the conclusion that I can be really quite screwed up. Trading-wise, that is.

But that’s to be expected.  Traders, especially traders who are still in the ‘getting everything bedded down’ phase, have to go out of their way to wrestle with their mind pretty much every time they put on a trade.

Sometimes the interaction is easy – you’re in the zone, you know what needs doing and can do it without too much internal push.

But other times when you’re slightly off kilter, the internal push is so strong that you have a hard time just thinking straight.

Never does this become more obvious than after a run of losses.

I’ve just come off a run of 10 straight losses.  To define that for you, that included eight 1R losses, one 0.5R loss and 1 break even.  Quite a patch, huh?

I’m not a good loser.  I don’t like to be wrong and it’s probably the biggest hurdle I have to deal with in regard to my own trading psychology.

So when I get to around 10 losses in a row, I’m starting to feel like I suck.  I’m starting to feel scared about losing any more money.  I’m starting to worry that all the profits from my last good patch will be decimated if I keep trading.

At least if I stop trading right now, my equity curve will continue to look pretty – kind of like Snow White frozen for eternity in her glass case – but unless I’m ready to quit forever, placing another trade is inevitable.

Common trading wisdom suggests that if you’re losing, cut back your size.

Cutting back trade size when you’re losing makes sense on many levels, because if you’re trading like a junkie or the market isn’t right for your style you don’t want to be flinging around huge positions.  It also makes sense to our hurt feelings – it feels much better to have a go with a teensy position because the damage will be minimal if you continue to be wrong.

I have a problem with this ‘wisdom’.  In fact I think it’s flat out wrong.  It might be good for the big guys – money managers and the like – but not for average retail traders.

The big guys generally don’t have the flexibility to pull the pin and sit out.  They are expected to trade no matter what.

But think about it from a retail traders perspective.  Generally, those of us who know what we’re doing already limit our risk through position sizing, and keep the risk in each position below the 2% mark.  We already have that in place to prevent blowing ourselves up.  Reducing our size has the potential to make our positions so insignificant as to be pointless.

While cutting our size does make us feel safer and helps to sooth our battered souls, it can actually be detrimental to our profitability – I realise this sounds like crazy-talk, but let me explain.

Look at the following graph, which shows a run of 10 1R losses, followed by a great equity rally.  Notice that after panicking at loss 10, the risk has been halved.

Cutting risk after 10 losses

Put yourself in the picture here.  You’ve just had 10 losses in a row, and are feeling hideous so you’ve cut your risk back to make sure you don’t lose too much.  You feel happier knowing that the damage is going to be limited from here on in, and continue trading.

You start to win again, which feels fabulous until you check your equity curve.  Even after all those wins, you’ve only just poked your head above water.  You’re not feeling quite so happy now, so given your recent good luck you go back to full risk.  And promptly start losing again, with full 1R losses.

Compare to this, which shows the same data without the cut to risk levels.

That is a huge difference.

By not cutting back risk you can now afford to host another run of losses, should the market decide to serve them up.  You never know what’s hiding just around the corner, but by cutting your risk after a bad run you are guaranteeing that you won’t be in a position to profit from good conditions.

If you feel out of touch and like you can’t catch a break, it’s time to back off – not from risk, but from trading.   Give yourself a couple of sessions to get your head straight, read something inspirational and just chill for a bit.  You’re not going to miss anything in a couple of days.

That doesn’t mean switch off, necessarily, in fact continuing your usual routine is a good thing.  Watch the market, journal your thoughts and get your confidence back.

And then, when you’re rested and certain a loss straight off the bat isn’t going to make you cry, you’ll be in a much better position to take on whatever the market throws your way.

***

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  • Projectx44

    Gambling is always a part of trading……High Leverage Forex Brokers

  • tw

    The risk that you are not taking into account, while articulating it in your post is the emotional one. If your strategy is purely systemic, then it’s ok; but if 10 losses in a row get you down then it’s the emotional capital that requires protection. That means being more flexible in cutting back and scaling up rather than depending purely on the numbers game. Not very apropos in today’s all math all the time market, but reality if you use any discretion in your activities.

    tw

    • http://www.roguetraderette.com/ Jessica Peletier

      Your right about the emotional side of things for sure. Like I said though, I prefer to take a break, get steady and refocussed and then get back in with normal risk levels rather than staying in, and trading off-center with cut risk levels.

  • Brmr

    In trading it’s better to be approximately right than being precisely wrong.
    Bet sizing is the range at which you can still make mistake or be wrong without it adversely affecting you. And it works in many ways, you can equal size all you bets when you do not know which ones are the best and which are worst.
    You can vary that by slightly increasing the bet size on the best ideas and reducing on the not so great ideas. That’s where you need your edge to determine which is best and which is not for discretionary traders. as for systems they tend to rely on equal bets.

    • http://www.roguetraderette.com/ Jessica Peletier

      In my situation, I risk 1% to start, then load up when things are going my way. So if the initial 1% goes bad, it’s alright – it’s the smallest position I ever carry. Thanks for the detailed responses, I appreciate it :)

      • Brmr

        Thank You. Could you clarify how you got that graph as when i try to do that with payoffs it has different slope. But without Payoff calculation i am getting similar slope. I am using 2.5R as payoff.

        NIce work though.

        • http://www.roguetraderette.com/ Jessica Peletier

          I probably did it the long way, I’m not an excel pro! I used random data chunks of my own, then wrote a quick formula to add a running total. I didn’t use a particular function to create the graph. It was just done to show my point, more than anything.

  • Brmr

    http://martinkronicle.com/2012/01/08/aaron-browns-red-blooded-risk/

    LEE – Here is the interview of aaron brown about kelly criterion and why it is used.

    As Ed Seykota says kelly criteria is the cliff before the fall

  • Brmr

    We didn’t use the Kelly criterion at all in trend-following because the bet size was such a small fraction of Kelly that it didn’t make any difference. I would guess that we were probably using something equivalent to 1/10 or 1/20 of Kelly. – Ed Thorp

    It all depends on how confident you are about your edge. If you have a really strong conviction about your edge, then the best thing to do is sit there and take your lumps. If, however, you believe there is a reasonable chance that you might not have an edge, then you better have a safety mechanism that constrains your losses on drawdowns. My view on trend-following was that I could never be sure that I had an edge, so I wanted a safety mechanism. Whereas for a strategy like convertible arbitrage, I had a high degree of confidence as to the payoff probabilities, so reducing exposure on drawdowns was unnecessary. – Ed Thorp

    We also had a risk management process that worked a bit like the old portfolio insurance strategy. If we lost 5 percent, we would shrink our positions. If we lost another few percent, we would shrink our positions more. The program would therefore gradually shut itself down, as we got deeper in the hole, and then it had to earn its way out. We would wait for a threshold point between a 5 percent and 10 percent drawdown before beginning to reduce our positions, and then we would incrementally reduce our position with each additional 1 percent drawdown. – Ed Thorp
    (http://abnormalreturns.com/ed-thorp-on-trend-following-an-excerpt-from-hedge-fund-market-wizards/)

    That’s crucial for Money Managers a they have limit on Drawdowns. Beyond which redemptions might start and other uncle point related issues. On the other hand like Ed Seykota informs on his web page You increase your size in the same manner when things work out in your favour like pyramiding.

    I am paraphrasing here what i understood ED was saying if you are betting .75% on each bet after 5 consecutive losses reduce it to .50% and then to .35% after another 2 losses in the same manner increase your bets from .35% after 2 wins to .50% and after 4 wins to .75% that’s the asymmetric probabilities based on theory of runs. which was elaborated by Aaron Brown.

    AARON Brown on KELLY Formula

    Mike: [laughs] Yeah, and it’s cheaper, exactly. So, we were talking about has anyone here seen Kelly, and the importance of the Kelly Formula in terms of being able to calculate the amount of risk you would allocate to a certain strategy. Why don’t you bring us up to speed on Kelly, and how it’s used on Wall Street, if it’s at all used, and then we’ll take it to the next step.

    Aaron: When people talk about the Kelly Formula, they get sort of obsessed with the mathematical formula, which isn’t the point. It’s a key insight about the nature of risk, and Kelly was this follow who worked at Bell Labs and unfortunately died young. He was also a fighter pilot, he was an expert pistol shot, and fast draw pistol champion.
    He lived a very exciting life, a Texan. He started thinking about the right way to bet on horses. He came up with this insight, which is actually kind of trivial mathematically, but I won’t go into that right now. Most people think if you keep more risk, you increase the chance of very good or very bad outcomes. What Kelly showed, was beyond a certain point, increasing risk just increases the chance of very bad outcomes.
    There are some levels of risk that are just stupid to take. You can just calculate the amount in certain casino settings, where you know all the variables, and the odds, and so forth. In real life you can’t calculate that precisely. If you take your risk up to the Kelly point, up to the maximum point of risk, you’re guaranteed to do better than someone who bets any other way, in the long run.
    The key to success is sizing your bets correctly. People are upping their bets and risk all the time, that’s life. They either make financial bets, like trades, gambling games, decisions like do I quit my
    job and start a company, do I go back to school, do I marry this person. If you can calculate the right size, you get carried along, you’re going to win some and lose some, but you can have faith that in the end you’re going to end up better off than any other way.
    If you don’t think in terms of good bets and bad bets, the question you’re always asking, is what’s the right size. This insight can be incredible valuable to trading, I think. A lot of traders come up to you with good ideas and bad ideas just don’t think about it that way. You say “OK, I’ve heard your idea, here’s the right size.” The right size might be zero or a penny or a dollar, or the right size might be everything you can beg, borrow and steal, but there is just a number that is the right size.
    What people tend to do without Kelly, is they put a very high standard on any risk they are going to deliberately take. They just lose out, because 99% of the bets they should be making they’re just not making. Maybe they should be making them smaller, but they are not making them at all. The positive expected value of those bets, over 99 bets, you really eliminate most of your risk.
    Because if you flip enough coins, you’re going to get the expected number of heads. When something comes along that they should bet – this is assuming that people are correctly identifying the good bets, which not everybody can do – they bet way too much on it. If they win, they talk about how smart and bold they are.
    These are many of the most successful people in the world follow that strategy and people look at them and try to imitate that strategy. They don’t realize that it was a fool’s strategy that just happened to work out. If the person loses their big bet, they blame it on black swarm, an unexpected event, it’s not my fault, I couldn’t control it, but in fact they could.
    They could have made a hundred smaller bets, they would have been guaranteed to be in a better place. That’s what Kelly really teaches us how to do. It teaches us the questions we should be asking. In any practical real life bet, you can’t calculate all the odds, exactly.
    You don’t exactly know all the payoffs. It’s not like you can take a piece of paper and say, this is exactly the size. You can get pretty good at estimating the approximate size, if the size is approximately right, you’ll do pretty well. If you’re getting your sizes wildly wrong, which most people do, you can’t win.

    Sorry About the length of those answers hope these will be of some use

  • Guest

    I’m not sure that your hypothesis is correct

    • http://www.roguetraderette.com/ Jessica Peletier

      You have to bear in mind that I’m speaking with the assumption (as I stated in the post) that risk is already capped at a percentage of capital. So after a run of losses your risk is already organically reduced, because your account is now smaller, therefore your risk % is also smaller.

      I believe that further reducing risk, like halving it for example, can be detrimental to overall profitability.

  • http://www.brandnet.com/ Brandnet

    Nice post, nice thinking.

  • tw

    Your performance should be informational. Losses are an opportunity to examine what isn’t working, scaling back reduces pressure and emotional volatility. Less pressure and emotional volitility means clearer thinking and the ability to examine the situation and the trades you are making from a different vantage point.

    Cut back a bit after multiple losses and focus on process and scale up a bit when you are back in tune. Too much focus on equity curve can alter your process and change focus (for some leading to the need to “make it back”) Process and working around process is key. The need to be right (something I understand well) is a tough way to make a living. Perfectionism can be adjusted by seeing every trade as informational neither right nor wrong.

    tw

    • http://www.roguetraderette.com/ Jessica Peletier

      You’re right regarding the need to focus on process – I’m just reading One Good Trade by Mike Bellafiore and it’s just the kick I needed. Sometimes the end result gets way too much attention, when it should be one good trade, followed by one good trade followed by one good trade.

      Thanks for your response!

  • txbondman

    I sometimes say it this way — if you walk into a bar swinging a broken bottle and a rusty bike chain, you will probably not be able to walk out of the bar flashing a sheepish grin and a weak nod. After you recover, you can reconsider your approach and your position size. This, of course, assumes that you know what you are doing and that your problem is bad trades, not bad strategy.

  • http://curvededge.wordpress.com/ lee

    understood……cheers,

    Keep up the good work. Hope you’re winning again now. Whatever market you trade is tough these days.

    L

    • http://www.roguetraderette.com Rogue Traderette

      Thanks Lee, the drought has broken but it’s still not easy – pretty choppy markets in FX atm.

  • http://www.roguetraderette.com Rogue Traderette

    I think you’ve misunderstood me, Lee – if you’re trading 2%, and you’ve had a run of losses, your 2% now will obviously be smaller than before the losses.

    What I’m talking about is not that organic fluctuation of risk, but more drastically reducing risk, by going from 2% to 1%, for example.

    Using a percentage of capital as risk automatically changes what we risk per trade anyway, so big cuts to risk should be unnecessary, and potetially harmful to the account.

  • http://curvededge.wordpress.com/ lee

    I’m disapointed you think that way Jessica, position size is meant to be a % of your account balance. If it is your business you need it to grow, as you win your size should increase. This also means that when you lose and your account reduces so should your size. Doesnt matter if your small retail or the london whale, that rule creates clear thought and longer life expectancy. Look up the Kelly criterion.

    Thanks
    Lee