Larry Hite on Risk Management for Trend Following Traders

I have mentioned before that the world of trading is filled with paradoxes.   Another paradox in the trading world is that the subject that will determine at least 90% of your results is hardly ever mentioned.    That subject is risk management.

The greatest piece of advice I can give to new traders is that they should only risk 1% of their account equity on any given trade.   This means, for example, if you start off with $10,000, place your first trade, then get stopped out, your account equity should now be $9,900.

By risking only 1%, your account is able to survive many losing trades in a row.   But how many losing trades in a row should you prepare for?

Let us say that 50% of your trades are winners.   The table below illustrates how many losing trades in a row you can expect, mathematically:

As the table above shows, over the course of the next, say, 100 trades, you can expect to run into 7 consecutive losing trades in a row.

The next table shows the resultant drawdown you can expect from those losing 7 trades in a row based on different bet sizes:

The table above shows that, for example, if you bet 5% on each trade, then 7 losing trades in a row will drawdown your account equity to $6,983.   And this is the scenario based on just your next 100 trades. If you trade over the course of years and decades, you could easily run into a patch of 14 or 15 losing trades in a row.

This is why, in my studies, I have come to the realization that all old traders bet small.  The reason is that had they bet big over the course of 15, 20, or 25 years, they would have gone extinct and I would not have been studying them in the first place.

Bottom Line:  If you don't understand bet sizing and risk management you will, mathematically, go bankrupt eventually.

  • Two basic rules:  1) If you don't bet, you can't win.   2) If you lose all your chips, you can't bet.
            -Larry Hite