The New Chewing Gum Brand for Traders is Called Risk Management

Recently, the frequency of articles and books for traders and investors in which it is asserted that the key to success is risk management has increased. Risk management is obviously important but it is not the key to success as its main purpose is to minimize losses and maximize gains of a strategy that has a positive expectation. A trader or investor with a high success rate in identifying opportunities has better chances of outperforming a lousy win rate with good risk management.

Apparently, some people are not straight forward with traders and investors and some others are diverting attention from their proprietary methodologies which are very difficult to explain due to their complexity by offering to their interviewer this new chewing gum. If you have a highly quantitative strategy for generating entry and exit signals in a variety of markets and suddenly someone calls you on the phone or sends you an email that he is writing a new book on successful traders and he wants to include you there along with your secret to success what are you going to do? Obviously, you are a polite person and you are not going to hung up the phone or reply with a flat “No, bye”. You then offer to him some chewing gum, this new brand called risk management, and you say that your secret is the way you manage your risk. Which is part of the truth but not all of it.

It is amazing how some people write blogs and even books where they scream loud that the secret to success is risk and money management. If that were the secret, big investment houses would not need all those analysts for every sector of the market and for every major name and would just open random positions and have mathematicians manage the risk. However, the practice of winning investment houses for many years provides a clear indication that identifying value opportunities and the proper timing of trades and investments is the primary key to success. Risk management comes after that. It is important but only as a means of maximizing some objective, in most cases that being the net profit, or minimizing net loss in case that the market turns against them. Thus, those who make the naive claims are empirical fools.

There are even cases where risk management is not even effective regardless of its sophistication. This includes undercapitalized traders. Unfortunately, most retail traders are undercapitalized for what they want to achieve. Nothing in the world will help you if your risk percent is in the order of 20% of your bankroll, not even a supercomputer running the most sophisticated risk management algorithms.  But to limit percent risk to below 2%, a level recommended in the past by many successful traders, requires account sizes beyond those that 95% of retail traders can afford.

On the other side of this controversy are some technical traders who insist that their success rate is unimportant because when they win, they win big time due to their “sophisticated risk and money management”. I think even a high school kid can run a simulation of 1000 equity curves for low win rate and high average win to average loss ratio that will show that the statistical significance of such claims is very small. Most traders who rely on occasional hits eventually go bust. Few may survive if they are lucky. This is all so trivial that does not even worth mentioning. Yet, many poor souls get sucked in by advisers who make streaks of bad calls until eventually get it right while at the same time claiming that they manage with the one good call to be profitable. This is laughable but may inexperienced traders and investors fall victims of such claims. If you do not believe me, just take a coin out of your pocket and start tossing it. Even with a 50% win rate, a streak of losers right from start to ruin the account is always possible. Imagine what happoens when the coin is biased and the win rate is only 20%…

So when someone argues that his secret to trading success is risk management you can ask him to accept the challenge of 10 random entries from 20 markets, like in S&P 5oo, SPY, QQQ, GLD, SLV, corn, sugar, crude oil, etc. and prove to you that he can overall make profits. Actually, you can use a D20 for that. No matter how sophisticated the risk management is, the gum chewing trader will be ruined with probability 95% or higher.

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