Seasoned traders know the importance of risk management. If you risk
little, you win little. If you risk too much, you eventually run to
ruin. The optimum, of course, is somewhere in the middle. Here, Ed
Seykota of Technical Tools and Dave Druz of Tactical lnvestment
Management, using subject matter and materials that they have used in
lectures and workshops around the US, present a method to measure
risk and return.
Placing a trade with a predetermined stop-loss point can be compared
to placing a bet: The more money risked, the larger the bet.
Conservative betting produces conservative performance, while bold
betting leads to spectacular ruin. A bold trader placing large bets
feels pressure or heat from the volatility of the portfolio. A
hot portfolio keeps more at risk than does a cold one. Portfolio heat
seems to be associated with personality preference; bold traders
prefer and are able to take more heat, while more conservative
traders generally avoid the circumstances that give rise to heat.
In portfolio management, we call the distributed bet size the heat of
the portfolio. A diversified portfolio risking 2% on each of five
instrument & has a total heat of 10%, as does a portfolio risking 5%
on each of two instruments.
Our studies of heat show several factors, which are:
- Trading systems have an inherent optimal heat.
- Setting the heat level is far and away more important than fiddling with trade timing parameters.
- Many traders are unaware of both these factors.
One way to understand portfolio heat is to imagine a series of coin
flips. Heads, you win two; tails, you lose one is a fair model of
good trading. The heat question is: What fixed fraction of your
running total stake should you bet on a series of flips?