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Minimizing Portfolio Risk with Dr. Alexander Elder’s 6% Rule

In The New Trading for a Living, Dr. Alexander Elder suggests two methods for controlling risk. Previously I wrote about how the 2% Rule will mitigate risk when building a position. Elder’s other risk guideline, the 6% Rule, can be used to minimize risk at the portfolio level. Just as the 2% Rule puts solid risk management in place at the position level, the 6% Rule provides a useful risk constraint for the entire portfolio.

Specifically, the 6% Rule restricts traders from allowing total outstanding risk of all positions to exceed 6% of the portfolio value as of prior month-end. The 6% Rule protects your account from incurring a series of small losses that amount to one large, meaningful loss. For example, a 1% loss may seem innocuous however once a series of five or more of these accumulate in your account in one month the losses will begin to be felt both financially and psychologically.

To an extent, the 6% Rule works against human nature. That is, as traders begin to experience a drawdown they are more inclined to trade more often or in larger size in order to try to make up for the losses. However, with a 6% risk constraint imposed on your portfolio you will be able to avoid these harmful actions to your account by taking a time out from trading to reassess your system.

Moreover, Elder states “The 6% Rule prohibits you from opening any new trades for the rest of the month when the sum of your losses for the current month and the risk in open trades reaches 6% of your account equity” (The New Trading for a Living, 208). We all go through periods when our systems are out of sync with the markets. For example, during a range bound market a Trend Following system will experience choppiness in its P&L. At times like this professional traders may take a break or scale down trading size. For example, Marty Schwartz mentions in his book Pit Pull that “the best way to stop a losing streak is to STOP! STOP THE LOSSES, STOP THE BLEEDING. Take time off and let your intellect take charge of your emotions; the market will be there when you return” (Pit Bull, 110).


As a natural function of the 6% Rule, traders will begin to see a shift in mindset that makes them think like a professional. That is, instead of contemplating how much money is available to trade as an amateur would do, you begin to think of risk in percentage terms like a professional. This shift in mindset will allow for you to begin developing the habits necessary to be in the professional ranks. Practicing strict enforcement of the 6% Rule will help you create this professionalism.  

While the 6% Rule serves as a portfolio constraint, there is some leeway around its restrictions. For example, if your account is at or near 6% of its maximum risk and a very attractive trade idea presents itself, there are two options to pursue. First, you can tighten up existing stops to create more latitude for another position. For instance, you advance your stops on winning positions so that your outstanding risk decreases to less than 6%, which opens the door for a new position to be created. Alternatively, you could scale down or close out of an existing position and redistribute the capital from a former trade to this new opportunity. This option may be best suited for trimming a lagging position or a holding that has advanced too quickly and then using the capital for the new trade idea.

Both of these options provide an additional benefit to the 6% Rule. Namely, traders will learn the art of setting and advancing stops when a risk budget is put in place for the account. Learning this skill will prove invaluable in your development. In other words, it takes practice and back-testing to determine the best stop loss level for your strategy.


As a trader you will be able to better manage your emotional and psychological swings through using sound risk control at the portfolio level by incorporating the 6% Rule. Developing the habit of executing a strategy over a long period of time and using practical risk management will provide traders with a better chance of earning a positive return. Implementing the 6% Rule will put portfolio risk management in place to help your trading immediately.

As always, please feel free to contact me with any comments or questions. Thanks for reading.


John
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