Mind if I talk a little bit about risk management?
In his book, The New Trading for a Living, Dr Elder uses the analogy of swimming to discuss risk management, saying that there are two kinds of danger the swimmer faces: sharks, and piranhas.
The ‘shark’ is that one big trade that goes wrong, taking a massive bite out of your trading capital in a single shot. For this reason, he recommends never risking more than 2% of your account on a single position. This is fairly easy to understand, and to apply, and is all over the internet. You are clearly aware of this rule, and have been managing your position sizes accordingly, so I won’t say any more about it.
The ‘piranhas’, on the other hand, are the string of individually acceptable losses that nibble away a substantial part of your account, almost without being noticed. For this reason, Dr Elder suggests that if you ever suffer a 6% draw-down that you stop trading for the rest of the calendar month - you are clearly out of sync with the markets and need some time to put yourself right, or let the markets return to normal, as the case may be.
I rarely see anyone reference this rule, but I found the implications staggering. Whereas the first rule requires you to manage risk in reference to your account size, the second rule requires you to manage risk in reference to your account size and your hit rate.
Let me give you an example by comparing two profitable systems. Don’t worry about the R:R ratio, just accept that both are profitable in the long run.
The first system has a 90% hit rate. If a 2% position size is used - the max allowed by rule 1 - then a 6% draw-down - the max allowed by rule 2 - will involve three consecutive losses. The chances of that three loss streak starting with any given trade is 10%x10%x10% = 0.1%. The odds of this happening, and thus being locked out of the market for a couple of weeks, is so low that a 2% position size can be used.
The second system has a hit rate of 25% - it’s all about picking the big winners. If a 2% position size is used the chance that any given trade is going to be the start of a three loss streak that locks you out of the market is 75%x75%x75% = 42%! Using a position size that is perfectly permissible under rule 1 has nearly a 50% chance of locking you out of the market after only three trades under rule 2! Every month!
But suppose that system instead used a 1% position size. Now, a lock-out only occurs after a string of six consecutive losses. The chances of this six loss streak starting with any given trade is only 18%, a far more reasonable number. Still a little high for my tastes, though. What about a 0.5% position size? Well, that requires a 12 loss losing streak, and the chances of that beginning on any given trade are only 3%. Much better!
So, as you can see, the 2% rule is only half the story, with the 6% rule being the other half. I mention this because your last account update is showing a draw-down of 4.8%, and you are talking about increasing your position size when, respectfully, your hit rate rather suggests that you should be reducing it.
Obviously, there are ways to hit a max draw-down other than a string of consecutive losses. I’ve tried to keep things simple, though, to illustrate the basic point.