Trading is risky. “It’s not whether you’re right or wrong that’s important, it’s how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros, the man who broke the Bank of England. Risk management will define how much you win or lose when you are right or wrong.
Every broker discloses that, ‘trading is risky’ to the extent that you can even lose all of your capital. For a fact, a broker which doesn’t have that warning wont do you any good. There’s every bit of truth in that; but are you aware that, you can define the risk you are comfortable with 95% of the time?
The 2015 EURCHF crash which did not regard risk management.
If you are a good risk manager, it is only unforeseen circumstances like the January 2015 incident of the CHF that can actually make you lose all of your capital.
This was when the Swiss National Bank unpegged the Swiss Francs from the Euro. The EURCHF pair crashed, stop loses weren’t activated at set prices and many traders lost their accounts. Even brokers weren’t left out of the losses as some of them went out of operation.
Events such as this are known as Black Swan; no one has control over them. They are like natural disasters, but the good news is that, they are very uncommon so you can implement risk management and stay safe most of the time.
Risk management goes hand in hand with risk aversion.
As a forex trader you have to define the percentage of your capital you can risk. This percentage must be the biggest loss you can handle. That means that if you end up in a loss, your trading career would not end or if all else goes wrong, not even 20% of your capital would be gone. It all comes down to who you are and knowing yourself best.
The way this market can react at all times, it is advisable to risk at most 2% of your account capital on each trade. Utmost conservative traders risk 1% whilst aggressive traders aim for a 5% risk. Forex trading success lies in Risk to Reward ratio, of which traders must only target 2:1, 3:1 and as high as realistic. More on Risk Management here.
It is also advisable to cut risk in half when your trading account is suffering a drawdown. Thus 1% risk would be 0.5%, 2% would be 1% and 5% would be 2.5%. What is not advisable is increasing risk haphazardly when your trading account is growing. There should always be some rules guiding the increment of risk in a growing account.
A story of two traders and a case for risk management.
The aim of this post is to tell you about the story of 2 traders; a conservative one and an aggressive one. It was told by Nassim Nicholas Taleb in his book, “Fooled by Randomness”. After reading the story decide for yourself the type of trader you would want to be; a risk manager or a risk seeker.
Trader A (Nero Tulip); risk manager.
Nero Tulip, an academically inclined personality in the field of Statistics was not having enough fun in his field; so he ditched academic work to trade after an encounter with a trader. He started at the Chicago Mercantile Exchange with competence in quantitative financial products.
His credentials caused a soar in his demand amongst the New York and the London Exchanges. As a high risk averse trader, he rose through the ranks to become a proprietary trader with a yearly income ranging between $ 300 000 – $ 2 500 000.
He made sure to invest his profits in only treasury bonds issued by the US government. To Nero, that was a safe investment because governments seldom go bankrupt.
He was flat in the whole year of 1993 when his fellow traders were raking in profits. This caused the superiors in his trading firm to reduce his trading capital; that however wasn’t going to be a worry later; as his risk management prowess gave him longevity in the game.
Trader B (John); risk seeker.
John (the high yield trader) is the complete opposite of Nero. John’s trading style is “high yield”; investing in risky assets and hedging. The strategy was to acquire “cheap” bonds and profit from interest rate differential by using the heaviest leverage possible.
Giving off the impression as a professionally born business person, he also rose through the ranks to head a team of ten traders, all of whom mimicked his trading strategy. John was deficient in math due to his poor educational background, so he always fell on his assistant, Henry, for risk management purposes.
At the peak of his trading career, he was worth 16 million dollars with 14 million invested in stocks unlike Nero who preferred treasury bonds (considered safe investment).
Living across the street from Nero, his is the plush lifestyle with a mansion that housed two German cars and two convertibles (of which one is a Ferrari). Nero had driven a VW cabriolet for almost ten years.
John was five years younger than Nero, yet he was making 10 times of Nero’s income. Sometimes John ignored Nero and whenever they bumped into each other he looked down on Nero as an inferior through his actions and inactions.
In 1994, the bond market crashed due to random Fed rate tightening; Nero’s colleagues blew up. He saw traders accumulate profits for months only to lose them in hours. These and many other experiences helped him maintain his calm in the face of John’s disrespect.
When asked why he was such a conservative trader upon quickly exiting losing trades, he replied; I was trained by “the most chicken of them all” (a Chicago trader only named as Stevo).
In the summer of 1998, Nero was to be vindicated when the value of high yield bonds took a deep dive down. What looked like a meltdown was actually the market reverting to its mean. Note that, the dip was not a very large one but John’s leverage was gigantic.
His team of traders were in the same situation since they followed his strategy without question. John raked in profits of about 250 million dollars within a period of 7 years but lost more than 600 million dollars for his last employer. His net worth estimated at about 16 million dollars was barely 1 million after the loss. His career ended as he lost his job.
Nero retired as a happy millionaire after 14 long years in business. He went back to school to obtain his Doctorate in Statistics which he ditched for trading. He had saved enough money to do the things he loved; reading and working out.
He ended up as a part time lecturer. The author describes him as a “conservative trader with good years, less than good years and no bad years”. Nassim also attributes Nero’s success to his mathematic nature and his deep understanding of probability.
As you can see, bad risk management shortens the career of traders from the story above.
Now that we know the intensity of the phrase, ‘trading is risky’; you need to learn from the classical story these of two traders;
- Manage risk.
- If you can’t experience John’s success, you can’t suffer his downfall.
- John’s Leverage will compound your small losses to wipe you out.
- Like Nero get out of loses quickly, don’t set and forget.
- Don’t question your strategy if Nero agrees with it, you might even go past his 14 years. (Stay away from leverage, prolong your trading account and career)
- All trading is probability, lose some, win some but lose small and win big unlike John in the end.
- Conservative trading is slow paced but it has a long term reward; Aggressive trading is fast paced but you stand the risk of losing everything if a little goes wrong.
- Manage risk.
Form the story above, it is not really surprising as to why brokers never hide the fact that trading is risky. Both consecutive and aggressive trading have their risks and rewards. The onus lies on you to decide which style you want. Any other classical lessons learned aside from taking risk management seriously? I would like to know in the comment section.