Some Thoughts On Risk Taking

We received a few e-mails in regards to our last post where we discussed our performance. One of the things that was brought up a few times was why we have self-admittedly taken on too little risk. The simple answer is that we don’t like to lose money. Drawdowns are not something that we enjoy that much.

For a better explanation, let us first explain how we trade. Our basic method of scaling risk is described in the Stanley Druckenmiller interview in The New Market Wizards by Jack Schwager and is further explained in the interview with Christian Siva-Jothy in the book Inside The House Of Money by Steven Drobny. You start out by generating positive returns, and once you are up enough for the year, you can start taking on more risk. For example, if we are up 20%, we don’t mind taking on a risk that could potentially take us down 5%. We’d still be up 15% for the year. On the other hand, if we are only at 0% for the year a -5% hit would be really bad. So basically we trade away with strict loss limits until we are up enough to start raising our risk limits.

We strive to deliver good trading ideas on an absolute and on a risk-adjusted basis. A 50% gain is great, but if you had to risk 100% to get there, then it doesn’t look too good anymore. In that case, being wrong once blows up your account.

You can find more of the same in several other newsletters. For instance, if you pick up a copy of the Hulbert Financial Digest, you can find scores of newsletters that manage to have one 100%+ year and then proceed to lose -87% the next year, -37% the year after that, and so on. Trade like that and you’ll be lucky to have a whopping $10 bucks left in your account.

Happy Trading,

The Macro Trader

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