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Common Sense Risk Management Rules

In his book, Trading Systems and Methods, Perry Kaufman provides some simple, non-mathematical rules that all traders should employ when running a trading program. While there is a purpose and time for using statistics and more advanced mathematical concepts to manage risk, these guidelines will help keep your trading on the path to profitability.  


  1. Only risk a small amount of total capital on any one trade. This suggestion echoes the teaching of Dr. Alexander Elder who popularized the 2% Rule. Simply put, when trading you should never exceed a particular amount of risk in any one position that could compromise your performance. In the futures industry, risk-based position sizing algorithms are commonly used to determine the ideal position size or Optimal f.
  2. Know your exit conditions in advance. Kaufman states that “There should be a clear exit criterion for every trade, even if the exact loss cannot be known in advance.” In other words, if you are trading a moving average cross-over system you cannot know the exact dollar loss when putting on the trade as you would when using an initial stop loss, however the cross-over rule provides clear exit conditions upon the onset of the trade.
  3. Large profits mean large risk. Here Kaufman is implying that more risk must be assumed to generate a larger potential gain. If you are uncomfortable taking on the additional risk to generate a larger profit potential, then keep the position size smaller.
  4. Exit a trade quickly. Closing out a trade as soon as it goes against you is a universal trait of successful traders. Naturally, with a Trend Following strategy, cutting losses quickly and letting winning positions run is a common practice that is referred to as conservation of capital. Don’t fall victim to behavioral biases and attempt to rationalize staying in a losing position. Any change in parameters in actual trading will cause your results to deviate meaningfully from the back-test simulations.
  5. Don’t meet margin calls. If a trader is being issued a margin call it is probably “time to review trading performance, not invest more” as Kaufman advises. Moreover, if in actual trading your system begins to generate larger losses than experienced in back-testing it could be a sign that your data was curve-fit or over-optimized, which would certainly call for a halt to trading, a re-evaluation of the strategy, and possibly new system design and testing methods.
  6. Liquidate your worst position first when lightening up. Kaufman says “profitable trades have proved that they are trending or performing properly; the losing ones have proved they are not.” If the market turns against your trading strategy it is best to sell your largest loser first to minimize further downside exposure.
  7. Be consistent with your trading philosophy. As mentioned above, do not deviate from your plan or you will get random, unexpected results. Take time to understand the limitations with your system and plan for how you will handle those situations. For example, a trendless period in the market is unfavorable for Trend Following programs. 
  8. Be sure the trading profile is compatible with your risk preference. After conducting a back-test you should have a reasonable understanding of the future risk profile for your trading system. If, given the parameters tested, you are going to put on too much risk then dial down the leverage, scale position size, or reduce the maximum portfolio exposure at any given time until the risk profile is in harmony with your trading psychology.
  9. Plan for contingencies. Simply put, be prepared for the unexpected. In trading terms we refer to unforeseen events as price shocks. When designing a system your tests should include multiple market cycles that will account for various positive and, more importantly, negative price shocks to give you an expectation for how your account will behave when another price shock of similar magnitude does occur.
Begin referencing these helpful guidelines routinely. Keeping these fundamental concepts in the forefront of your mind when trading will help ensure you get the best results.


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

John
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