Risk should be measured in three ways: Risk per trade, risk per sector and total portfolio risk or portfolio heat. The more risk per trade, the more volatility in your account.
Choose your own risk tolerance, but a good gauge is not to exceed 2% risk per trade. Risk per trade is how much money you are willing to lose on a trade based on your account size. An additional filter to include is maximum dollar risk per contract; 1% risk on a $200,000 account is a maximum risk of $2,000.
The next issue to consider is the maximum risk per sector. All markets in the same sector are correlated to some extent. Gold is correlated to silver, copper and even palladium. The same can be said for the interest rates, grains, currencies and stock indexes. You can have an appropriate level of risk per trade, but if you are trading Eurodollars, two-year-, five-year and 10-year-notes as well as the long bond or six currencies against the dollar, you have quite a bit of concentrated risk. You can wake up some morning seeing all those positions going against you. Consider a maximum of 5% risk of your account in any particular sector. This should keep you out of trouble, yet enable you to participate when there are trends. It also can help you select the best opportunities in markets within a sector.
The most important issue in trying to achieve risk-adjusted returns is to know how much total risk is in your portfolio. This total risk, or heat, is in your control and is your worst-case scenario. Look at your core equity, that is the equity in your account if you were stopped out of all open positions, and see what your open trade risk is. You must have a maximum percentage that is preset and written in stone as part of your rules. A maximum portfolio risk of 20% is a good standard. Assuming a diversified portfolio, there is almost no way you would see such a loss, but if you did, you would survive.
By keeping your total risk at safe levels, you are protected from sharp shifts in correlations. As they say in volatile times, all correlation tends to move toward 1.0. However, traders, particularly those managing other people’s money, should attempt to keep their risk capital consistent. In 2008 many futures markets became highly correlated. This fortunately led to strong returns as many trends developed, but smart managers reduced their position size as a result. This helped them shrink losses as market reversed in the middle of the year. It also probably kept down losses in what was a difficult 2009.
When diverse markets begin to move together, it means you have more risk. To keep your risk consistent, you must reduce position sizes.
Andrew Abraham has been investing in commodities and managed futures since 1994 and is in the process of registering his CTA, Abraham Investment Management, with the NFA. His blog is MyInvestorsPlace.com