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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