Risk management is crucial because all trading strategies lose sometimes.    By limiting risk, a trader has a chance to survive long enough to find a way to thrive.   The topic is way too big for my little glossary but its here because I want to encourage traders to think about risk.

Extra Insight: 
Funny Carrie Underwood parody reminder to manage risk:

Backtesting trading strategies provides insight into the risk of various trading strategies.   Understanding risk is the first step towards managing it.   A complete understanding includes the knowledge that there’s always the risk of something completely unknown and unforeseen happening.

Different people have different risk tolerance and even the same person will view various risk differently.  That means you have to decide for yourself what to risk.

Here are a few “rules of thumb”:

• Don’t risk more than you can afford to lose.
• Limit the risk on each position.  1% of your trading account risked per stock is a middle-of-the-road estimate.  By risked, I mean the amount lost if the stop is hit.  No stop?  Then limit the size of the whole position to a small fraction of your account.
• Limit the total exposure of your account.   What happens if all your stops get hit?   What happens if the market gaps past all your stops.   Make sure you can handle it.
• “Blowing up” means losing 50% of account value.   Don’t let that happen!

Here’s a link to the book advertised in the video: Mastering the Trade (McGraw-Hill Trader’s Edge).

(Backtesting Blog is an Amazon Associate.)

Updated 11/12/08.

Tags: backtesting, long, management, risk, sizing, stop, strategy, trading

Shorting is simply selling a stock you have borrowed but you haven’t yet bought.   The idea is to sell when the price is high and buy later when the price is lower.    Buying the stock then closes the short trade as the stock is paid back to the lender (usually the broker).  

Details on how to sell short are in Sell and Sell Short by Dr. Alexander Elder.

Extra Insight:

Short selling is more difficult to model for backtesting because not everything is reflected in the price.  Extra rules are imposed by the SEC such as no shorting until the price ticks up.  The SEC recently removed this one.    The stock also needs to be available to short — meaning someone has to be willing to lend out the shares. Often shares are not available when the price is in free fall.   As we see in the current crisis, new rules are created on the fly such as the one-month hiatus on shorting bank shares.  To be super-accurate, a model would need to have different shorting rules for different dates– something that is beyond the scope of most backtesting engines.   The upshot is that backtesting doesn’t model short strategies as well as it does long strategies.

Risk management is more important for short selling because a short seller loses money when the stock rises without limit.   In contrast, a buyer of a stock can only lose as much as they paid for it.

A portion of the proceeds of a short sale are available immediately.   Some traders (and mutual fund managers) will use the proceeds to buy shares of a different stock thus making their money go farther.

(Backtesting Blog is an Amazon Associate.)

Updated 11/12/08.

Tags: backtesting, Elder, long, management, risk, selling, short, strategy

Size Matters

Sizing is the rule for deciding how many shares or contracts to buy.

Extra Insight:

Sizing is critical to risk management, worthwhile returns, and also making comparisions between backtesting runs.   For the backtesting runs, I use a very common and straightforward sizing:

• If there is no stop loss for the strategy under test, my backtesting trade size is 1000 shares (and the amount at risk is the total amount of the trade).
• If there is a stop loss, my backtesting trade size is the nominal risk amount of $1000 divided by the distance from the expected entry price to the stop price.   If its a next-day market order then today’s close serves as the expected entry price.   This way, the risk amount is constant for every trade but the trade size varies in both dollar amount and number of shares.

(Backtesting Blog is an Amazon Associate.)

Updated 11/13/08.

Tags: backtesting, expectancy, loss, management, risk, sizing, stop, strategy, trade size, trading