Jungle Rules
Have you ever heard the rules of the jungle?
If you haven't heard them, here are the rules.
( Well if you have heard them, please bear with me, here is a repeat! )
Rule No. 1 : There are no rules.
Rule No. 2 : There are no more rules.
Well, I have just now described the trading arena. It seems that most of the individual traders are the ardent followers of the jungle rules. If you are not one of them, hats off to you!
The Trading Jungle
Trading is not as easy and risk free as it is being portrayed by the tipsters, charlatans, gurus, astrologers, sell side analysts and dealers ( brokerages ) and the analysts from the TV and the print media. That's why all of them including this author are in the business of doling out the big disclaimers always! Have you ever seen any other business where the disclaimers are used so extensively?
The business of trading is inherently risky. Since leveraged trading of the futures and options is the most riskiest and unpredictable business on the face of the earth, the long term survival of any trader requires a sound set of rules of the business.
Fundamental Rules of Derivatives Trading
There are only three simple rules here. And they are:
Rule No. 1 : Preserve the Trading Capital;
Rule No. 2 : Preserve the Trading Capital; and
Rule No. 3 : Preserve the Trading Capital.
The above is not a typo. If it seems like a mistake, it is purely intentional.
If a trader loses 10 % of his capital, he needs to make a return of 11.11 % on his capital to reach the original capital. If he loses 25% of his capital, the rate of return required to reach the original capital is 33.33 %. In case of a 50 % loss, the rate of return required goes up to 100 %. It is near impossible for a trader who has lost a significant part of his capital to continue to trade profitably because of the psychological or other issues involved. It isn't impossible, but nearly impossible.
That is why a trader requires a prudent set of rules to preserve the capital to ensure his long term survival in the trading jungle. These rules have generally many names, and some of these names are risk management, money management, position limits, position sizing etc. The term risk management includes all the later named concepts, but the term money management does not involve the process of position limits or position sizing.
The terms position limits and position sizing are one and the same.
Money Management - Putting Your Eggs in Different Baskets.
Money management is the process of allocating the risk or loss capital to each trade. Under this process the allocation is always made as a proportion of the trading capital. It can be allocated on the basis of a fixed unit method or a proportional method.
Dividing the capital in to twenty units and allocating each unit to a trade is an example of the fixed unit method. It may also be noted that the total capital is sufficient to cover just twenty trades in this case. It is learned that even in a fair coin toss situation, a continuous toss of ten straight heads or tails is possible in one thousand tosses. Under this fixed fraction scheme of things, allocation of risk capital rises as a proportion of the capital after sustaining losses and falls after the capital increases by substantial profits.
Therefore, the proportional capital method, which allocates capital as a fixed proportion ( %) of the trading capital always is the preferred method. This method solves the above two deficiencies of the fixed fraction system. In the proportional capital method, the amount allocated is reduced in case of losses and it rises where profits are available. For example, if a trader with a capital of Rs.1,000,000 loses it's 50 % and if he is allocating risk on the basis of a fixed proportion of 2 %, his allocation to each trade falls to Rs10,000 from the original Rs.20,000. Similarly, if he has made a profit of 50 % and his capital has risen to Rs1,500,000, his risk tolerance for each trade rises to 2 % of the increased capital which is Rs30,000 now.
The concept of money management has just been explained and understood. The next step is to match the allocated capital to each trade and that process is called position limiting / sizing.
Position Limit - Matching the Risk Capital with a Trade
In order to understand the concept, let us go back to our trade dated 1st April, 2011. The Nifty futures chart as on the day of the buy signal is shown below.
Nifty Future as on 1st April 2011
The discussion of the applicable stop loss is repeated verbatim here. "The suggested stop loss points for this trade is the minimum of (a) previous minor high (b) 5% of the of the futures closing price added to the closing price. If we examine the trade setup we can observe the following:
1. The previous minor high was formed at 5357 on 21st March.
2. The entry price of 5500 plus 5% of the entry value is 5225.
Therefore the minimum of the above, that is 5357 can be chosen as the stop loss point. The stop loss point is higher by 143 points and this is about 2.6 % of the entry price.
Since we have fixed the market determined stop loss as 143 points or 2.6% of the entry price , the question is, how we can match the risk points with our allocated risk capital. Let us assume that our trader is having Rs. 10,00,000 as capital and he has accepted a money management allocation of 3 % of the capital as risk capital for each trade. Therefore, the risk allocation for the trade is 3 % of the capital and that is Rs.30,000.
Now, let us find out how many Nifty futures can be bought with the total risk allocation being limited to Rs.30,000 and stop loss being limited to 143 points per Nifty future. This figure can be arrived at by dividing the total risk capital allocated ( i.e. Rs.30,000. ) with the expected per future loss of Rs.143. 30,000/143 gives us a figure of 210 units. Nifty futures are being traded in lots of 50 units and it's multiples. Therefore, we need to divide the allowable 210 units with number of units of futures in a single lot ( i.e. 50 ) to find the number of lots which can be traded. The answer is 4.2 lots. ( i.e. 210/50 = 4.2 ). This can be approximated either to the nearest whole number of 5 lots or to the lower number of lots i.e. to 4 lots.
We have just learned the process of position limiting. Therefore, position limiting is the process through which a trader finds out the optimum number of the futures or shares to be traded while keeping the trade subject to (a) a market determined stop loss and (b) the money management based risk allocation.
Points to Remember:
Allocate risk or loss capital as a percent of your total trading capital.
Find out a reasonable market determined stop loss.
Find out the number of units or lots of the instrument which can be traded under the above two parameters.
We have just now finished a discussion on how to limit our positions in the market to very low levels compared to the capital. One of the reasons is that the balance of capital can be used in some other time frames or markets as a diversification. But the most important reason is explained only in the next page named Risk Analysis.
Cheers and Prosperous Investing and Trading!!!
