Traders should be aware that investment or trading risk is of paramount importance. Markets are risky and you cannot control them; you can however control your money and choose to invest it wisely by reducing your risk on every trade you make. Each trade in your portfolio is important and you should lose the minimum when you are wrong.
There are many different ways and techniques to reduce your trading risk and potentially increase your return. In this post, I will present you some of these techniques and explain to you how each one can be implemented in QuantShare trading software. Be aware that these techniques will not automatically work and reduce the risk of all your trading strategies. Some of them will actually fit some strategies and other ones will fit some other strategies. You will not know which techniques are right for your trading system until you test them by doing some backtests. Doing some simulations and backtests to see the impact on your trading system is also of a paramount importance.
The first technique consists of using a position sizing money management script to reduce your trading or portfolio risk.
Position sizing consists of adjusting the size of a position an investor is going to trade. Trader's risk tolerance should be taken into account when choosing the appropriate position size method.
There are several position sizing methods you can use in QuantShare. You may also implement your own methods using the money management tool.
The following post introduces five position-sizing techniques available in QuantShare's sharing server (Fixed dollar amount, fixed risk per trade, volatility based position sizing, Kelly criterion, averaging down)
5 position sizing techniques you can use in your trading system
By adaptive strategies, I am referring to strategies or money management scripts that allow you to take trading decisions based on portfolio statistics (return, current drawdown, portfolio risk/volatility, equity, number of positive trades...).
For example, Trading the Equity Curve item controls the strategy exposure by measuring the portfolio previous year return. When this return becomes negative it instructs the trading system to invest only 50% of its equity and it restores that value to 100% when the return becomes positive.
Other adaptive strategies:
Adaptive Trading System - Percent Winning Trades for the Last N-Days
Adaptive Trading System - Minimum Percent Winners and Percent Invested
Hedging is a practice that consists of protecting your portfolio from risk. It is like insurance where you protect yourself from a bad event (and thus a drop in your portfolio value) by investing in an asset that will become highly profitable when that bad event happens.
Usually, you want to hedge by investing in one or a basket of assets that have a negative correlation with your portfolio equity.
The following money management script allows you to hedge any trading system by investing in futures contracts or ETFs such as the ProShares Ultrashort S&P 500 (SDS):
Hedge a portfolio strategy
Trade more securities
This is probably the easiest technique to implement. The idea is that by trading more securities (Max simultaneous positions in a portfolio) we diversify our portfolio and thus reduce our trading risk. However, most of the time, the profitability is also reduced.
Here is how to implement this:
- Update your trading system
- Select "Strategy" tab
- Update the number of positions field (click on that number to update it)
It is possible to optimize this field by selecting "Optimize" tab, clicking on "Optimization" button then adding a "Number of symbols" item.
Trade large cap stocks
Small cap are very volatile and thus more risky. One way to reduce your portfolio risk is by investing in medium or large cap stocks.
You can also invest in stocks that are trading more than X shares per day. Here is how to add a rule that prevents you from purchasing illiquid stocks:
buy = close * sma(volume, 5) > 200000; // Reduce your trading risk
The above rule instructs the simulator or portfolio tool to enter a new position only if its 5-bar average volume in dollars is higher than $200,000.
Decreasing your strategy leverage (margin) will certainly reduce your portfolio risk but in the majority of cases, it will also reduce your profitability. Again, doing your backtesting homework will tell you if decreasing your portfolio leverage is what you should do.
Reduce leverage in QuantShare:
- Update your trading system
- Select "Settings" then "Capital"
- Update the margin factor
- Set it to "0.5" to invest only 50% of your equity.
Note that in some cases, increasing the leverage will bring much more benefits to your trading system than to reducing it.