Death by Piranha Bites

Death by Piranha Bites

 

OK, so, the headline is a bit dramatic. But I’m not the first person to do that and, as you will see below, there is a relevant point behind it.

There are two ways to blow up your account. You can lose a large portion through placing too much risk on each trade.

Even if you have a trading plan with, let’s say, a 75% success rate – highly unlikely – it is still statistically likely that you will encounter times when you lose 5 trades in a row.

If you put 10% of your fund at risk per trade and you trade 5 times in a day then on a single day you could be down 50%.

If that happens, it’s not your broker that’s to blame, it’s not bad luck, it’s not the markets doing something wrong. It’s just probability and bad decisions on your part.

 

Control your Risk per Trade

You don’t need to start changing the way you find trades in order to ensure this does not happen. Indeed, you will fail if you do so since you will still be likely to encounter 5 losses in a row at some stage.

You just need to ensure that you put a smaller amount at risk on each trade. Regular readers will know that I recommend a maximum of 2% per trade.

But, even then, you are not safe. Let’s say you have 10 trades open in different markets with only 2% risk on each. What if they all lose due to a dramatic unforeseen market shock?

Suddenly you are down 20%. Unlikely? Hard to say but it’s certainly possible. Such is the complexity of the factors that drive markets that seemingly unrelated markets can all respond in an adverse way to a shock.

Alexander Elder describes this as death by piranha bites. Lots of small losses. For the record he describes losses due to excess risk per trade as death from a shark bite. It’s a pretty good metaphor.

 

Control Your Total Risk

To avoid death by piranha bites you need to ensure that the aggregate percentage of your account that is at risk at any time is not excessive.

The eBooks published by brokers seem to contain something of a consensus that a trader should not have more than 15% of their fund at risk at any time.

This means you could have 7 trades open with 2% risk on each and stay within the recommended limits. Are they right?

The total risk facing a trader is sometimes described as portfolio heat. A number of studies have shown that this does affect the likely returns earned over a period of time.

This means that for any given set of factors that determine profitability, the average open risk in a portfolio over a period will have an impact on the returns earned from that portfolio.

 

What’s the Best Temperature?

We ran a simulation of 1,000 trades to identify what the impact might be in the case of Binary Options. The simulation was set up to identify which level of total risk would maximize returns under different assumptions for the win rate and the payout ratio.

The results confirm that portfolio heat has a real impact and that there is a desirable level.

The best level of total risk – the optimal heat – is affected by changes in both the win rate and the payout ratio. However, the impact of the win rate is much greater.

The best results were achieved with quite low levels of heat. For example, if you have a payout ratio of 75% with 60% winners, this would be a profitable system with the highest returns when total risk averages 6.5% of the fund.

It is very important to note that this system results in negative returns if this average is allowed to rise above 13%.

In other words, keeping everything else constant, just placing more trades changes a winning system into a losing one because of the impact of sudden large portfolio losses.

However, if the average payout ratio achieved is 78% with a 60% win rate then the optimal heat rises to 9%. So the payout ratio is relevant.

But the impact of the win rate is much greater. For example, if the payout is 75% and a slightly higher win rate of 62.5% is achieved then the optimal heat rises notably from 6.5% to 12.5% of the fund.

If a win rate of 65% is achieved with an average 75% payout ratio then the optimal heat rises to 18%. But how likely are you to achieve this win rate?

 

How to Avoid Death by Piranha Bites

These results would appear to indicate that the total risk open in your portfolio at any time should certainly not exceed about 15% of your fund and should be less than 10% unless you are consistently achieving a win rate above 60%.

What if you are not achieving a win rate of 60%? The results clearly show that you will not win by simply trading more and putting more at risk. Quite the opposite in fact.

Based on these results, it is recommended that no more than 15% of your funds should be open to risk at any time. Furthermore, you should treat this as a ceiling and not a target.

So will you be safe then? Even if you have 15% if your fund at risk, you will probably not lose more than 10% at a single time under normal conditions.

That would be a pretty bad hit. But at least it’s one from which you can recover.


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