Latest posts by Michael (see all)
- Why it’s Important to Remain Emotionally Balanced for Superior Risk Adjusted Returns - November 17, 2017
- Two Essential Things Necessary to Achieve 10-Baggers in Your Portfolio - November 16, 2017
- The Hidden Meaning of Surrender in Trading and How to Discover What it Means to You - November 15, 2017
Calibrate the risk that’s appropriate for your account and your emotional constitution. If you are trading too big, sooner or later you’ll find yourself in a situation that you wish you weren’t in.
Risk Management & Position Sizing
Normalize risk across all instruments so that you can create risk units. This way, every instrument will be the same in terms of the risk that you’ll represent in your portfolio.
Many commodity traders use the 20-Day ATR (Average True Range) in order to calculate the daily dollar-volatility per instrument. Then, they divide that into the percentage of capital that they are willing to lose per trade.
If the Gold ATR is $2.50 (it’s not) then the daily dollar vol is $250 since the gold contract is 100 troy ounces. If you have a $100,000 account and you only want to risk 1% per trade, you can figure out the maximum number of contracts to trade.
$100,000 x 1% = $1,000
Daily Dollar-Vol on Gold = $250 ($2.50 x 100 oz)
Therefore, you can only trade 4 Gold Contracts since $1,000 / $250 = 4 contracts
You can also trade only 2 contracts and give them $5 of risk between your entry and exit. The risk to your portfolio will work out to be the same.
Then to manage the risk, if you enter the gold market long per your entry signal at X Price and place your protective sell stop $2.50 (the Gold ATR value) below the entry price.
Sometimes, the ATR-based risk on a particular instrument will be too big for you to trade given the risk amount of your overall portfolio that you are willing to take.
Say the 20-Day ATR on the ES (E-mini S&P) is 30 and each full point is $50, then the dollar-vol is $1,500. If you only want to risk 1% of your $100,000 per trade, the ES is too volatile for you at this point since $1,500 > $1,000.
This rule can help keep you out of trouble by keeping you out of trades that can might hurt you financially. Like in surfing, once you catch a wave that’s too big and powerful for your level of surfing ability, it’s too late to call time-out…you can’t just surf the small part of the wave.
Likewise, If you try to trade with a stop that is a fraction of the 20-Day ATR, you are highly likely to get stopped out for losses regularly. You can’t change the nature of the instrument. Think of the ATR like a personality gauge that will reveal the true identity of what you’re dealing with.
If you know someone who is a mean and nasty drunk, you can’t typically deal with them on only the good days. That’s why you have to avoid them altogether – just like instruments that have dollar-vol values that are too high for your capital. This is most important risk management concept to manifest in your trading DNA.
Keep in mind that measuring ATR can be done with a computer and you can backtest all your entry and exit rules with the risk across all instruments normalized. That is how you stay emotionally balanced
In doing so, you remove all the guesswork. You have the added benefit of not falling in love with any one instrument risk management wise since each trade will be the same percentage risk in your portfolio (at first, if you don’t add to your winners).
More importantly, you won’t become despondent when you lose money on any one particular trade since they all represent the same risk and therefore you’ll not be married to the outcome of any one trade.
It’s hard to remain objective, especially if you are looking at the headlines of the day for your trades. Trading a system can remove all of that for you, but you’ll still have to a) put on the trades and the protective stops; b) not over-ride the system and “not” take the signals; and c) not over-ride the system and put on trades that were not system generated.
Trading Commodity Spreads
If the volatility in the commodities markets are too great for outright trading, you can consider trading intra-commodity spreads. In a spread, you are simultaneously long and short two contracts of the same underlying but of different expiration months.
Instead of trading for an up or down directional trade, you trade the relationship between the two contracts for them to narrow or widen.
You are afforded lower margin with spreads, so if your account is smaller, it might be a good fit for you to get going in commodities. The good news is that most professional traders know the spread markets very well so it’s a good idea to learn them anyway at one time or another.
You typically have lower risk since you are long and short at the time time and the seasonality of physical commodities tends to be very reliable.
We have some free educational training videos for you on this topic.
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