Risk Management for Speculators & Trend Investors

Risk management is the absolute key to success for speculators and trend investors. If you can limit your losses and downsides, the upside will take care of itself.

Here are a number of rules to help you reduce risk in your trend investing portfolio.

1. Divide your total portfolio equity into equal sized portions.

Ten portions is good to begin with and you can expand to twenty equal portions as your portfolio equity grows and you gain access to more markets. Unless you are managing millions, there is no point into dividing your portfolio further. Keeping your portfolio equity portioned will help with setting risk levels and stop losses for each position later. It is also a good way to help you determine the number of markets you should monitor and trade.

 

2. Only put up to one portion of your portfolio to work in any one asset.

By limiting your bet size on any one asset, you are ensuring your portfolio stays manageable from a risk perspective and properly diversified for broad return potential. You never know which markets are going to make you your profits, so don't bet the ranch on just one or two assets. Cash, or short-term bonds, are a default holding so nearly your entire portfolio may be in cash if markets are not trending.

 

Example Assets Only

3. Trade diverse markets that provide returns which are independent of each other.

Trading only stocks and bonds will not provide you with a broad range of returns. Instead, monitor a range of uncorrelated and liquid assets: stock indices, currencies, precious metals, real estate, and bonds. If your account is larger and you have access to futures markets, include energy, grains, and industrial metals.

A lot of these assets can be traded with ETFs, but be careful to pick the right ones. You want liquidity and reasonable costs.

 

4. Determine the size of each position, including leverage, based on volatility.

Leveraging up your position can help increase returns on each position, but it also increases your chances of hitting a stop loss quicker than you need to. This can increase your whipsaw costs. Use Average True Range or Standard Deviation to measure the volatility of an asset. The asset's stop loss price should be a low multiple of ATR or SD.

Your stop loss price will help you determine an appropriate size for each position once leverage is factored in. Based on this formula, a highly volatile asset might be purchased with no leverage, or maybe less than a full position. Many assets can be leveraged up 2x to 5x or maybe more.

 

5. Never risk more than 2% of your current portfolio equity on any one asset.

Regardless of the size of the position and the amount of leverage used, the maximum loss of any trade should never be more than 2% of your portfolio equity. Newer and more cautious investors should start with a 1% maximum risk per trade. In dollar terms, if your portfolio equity is worth $100,000, your maximum equity loss on any of your positions should not be greater than $2,000. Limiting losses is the key to long-term success.

Source: Flickr - DoD News

6. Enter a Stop Limit Order on every trade set at your maximum risk.

To ensure your emotions don't get in the way of your trading, always place a stop limit order on every position. The stop price should be set at or near your maximum risk. Assuming you are risking 2% equity per position on a $100,000 portfolio, your stop price will never allow your total equity loss on any position to exceed $2,000. Move your stop loss up as your position becomes profitable, but never move your stop loss down.

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