Having discipline in your risk management for long term trading for profit

(Last Updated On: September 25, 2014)

Having discipline in your risk management for long term trading for profit

When you take spread trades, you will naturally take out some market risk via hedging.

There are set of parameters you can use to protect your downside.

You could use gross exposure limits. If you fund a retail brokerage account of $10K which becomes margin which is collateralized against your losses. If you gain $1k, you are now at $11k. Large cap stocks will allow 10x the exposure on what is in your account. You need to find the sweet spot with the maximum your broker allows. If you have 100x on a forex account which could $25kx100=$2.5m. If you lose 1% of it, you are technically blown out by the broker. Never ever receive a margin call from your broker. Set max exposure rate of 1-10x on large cap and 7-8x on a forex account. Commodity is 5-6x. You will never receive a margin call at these rates.

For example, a 100K with 25K deposited and 5% return. After exposure goes up 4x, 100K exposure on 8-10 positions with 25% cushion. If margin goes up to 30k, you can expose at 5x with total 150k on 10-12 positions. You need to increase your risk and diversity on portfolio. You increase your exposure as you improve to be more profitable. Your risk goes down as your portfolio becomes more diverse with a few more positions on each iteration. You need set up an upper limit with a upper limit of the exposure to apply. Your volatility of the portfolio will go up in the long run. In a pure long/short S&P 500 portfolio, never go beyond 6x exposure. A Standard Deviation 2 could knock you back to the start. If you add forex, the mix of the portfolio changes thing. After 2nd iteration, you want to ensure you add the right mix of forex, equity, and commodity so each month you get a nice return to rapidly build you portfolio. You could double your money after 1 year if you keep your exposure 5x with 25% annual return. You should add another 25K in 2nd second with another 50k added in third year. This can only be done when you when cut your losers fast and run the winners. with discipline in mind. Retail traders will pretty well break even at best.

For net exposure limits with cash. Put a net limit of 50% on the initial funded account. Net exposure =long exposure – short exposure. YOu have a positive net long exposure position which means you have a positive view on the market. WHy not just get a S&P 500 ETF? If you have a negative net exposure limit, you short with a negative view of the market. You have accepted market risk. This prevents you from having a huge improper risk on the market. Put a limit of 25% possibly on this for market view.

Beta hedge view: Stock beta value is the amount the stock moves historically give 1 unit move in the market. To hedge out market risk, take beta ratio of long divided by beta ratio of the short which will give you a beta of the spread.

Beta hedging can be calculated on historical prices with multi periods. You may not be successful all the time since it based on historical values which means it change. This will result in portfolio losses but could be a reason why. Beta changes can impact forecasting of sophisticated models. Other risk management parameters are also needed as well.

These risk management parameters will dictate how your portfolio will be structured. This an extra important reason why automated trading works better since you are not really trading like a human.

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