“Kovner maximizes the chances that he will not be stopped out of a trade that proves correct, while at the same time maintaining rigid money management discipline. The philosophy behind this approach is that it is better to allocate the predetermined maximum dollar risk in a trade to a smaller number of contracts, while using a wider stop. This is the exact reverse of the typical trader, who will try to limit the loss per contract, but trade as many contracts as possible – an approach which usually results in many good trades being stopped out before the market moves in the anticipated direction. The moral is: Place your stops at a point that, if reached, will reasonably indicate that the trade is wrong, not at a point determined primarily by the maximum dollar amount you are willing to lose per contract. If the meaningful stop point implies an uncomfortably large loss per contract, trade a smaller number of contracts.” – Jack Schwager
This is an excerpt from Schwager’s recap of his interview with Bruce Kovner in Market Wizards. This was by far the biggest takeaway from the interview for me. Kovner spent a good portion of the interview talking about risk and money management which we have noted are weak points in my trading. This paragraph really expanded my thinking.
On a typical trade, I generally invest about $1,000 of my $3,500 trading capital. I always follow O’Neil’s 7-8% stop rule and set my stop at 7%. A 7% loss on my $1,000 investment represents approximately 2% of my total capital. We all know that just about everyone says you should never risk more than 1% of your capital on any given trade. I never understood how I could adhere to both the 1% rule and O’Neil’s 7% stop because the numbers never seemed to work out that way. Obviously, I just didn’t want to see why…….I was (and still am) trading to big.
I’ve always ignored the notion that I may be trading with too much risk, because with my small account, a 7% loss on a trade generally represents less than my automatic weekly deposit into my trading account. However, as my losing trades have started to pile up over the summer, my lack of risk analysis has been nagging at me and this passage really opened my eyes. I can definitely see myself as the typical trader that Kovner is talking about.
On the flip side, I don’t believe that any of my losers ended up as winners that I got stopped out of too soon. At the very least this has not been a big problem with my trades.
How has risk analysis affected your trading? Are you the type that tends to trade to big with closer stops or do you push the stops back and take smaller positions?