A Dozen Risk Management Rules For Staying In The Game In Any Market Environment

“Risk comes from not knowing what you're doing"

‍~ Warren Buffett, billionaire investor

Bitcoin’s remarkable ascent from an essentially worthless digital token in 2009 to being worth more than $60,000 at its peak last year stoked many people’s imaginations as to what is possible through investing. Along with Bitcoin and cryptocurrency came the concept of “HODLing”. HODL is a term that was coined during one of Bitcoin’s big crashes in late 2012, and basically means "to hold and never sell". Long term passive investing in the stock market is nothing new, and it has been proven that simply buying the S&P 500 index and holding it over time and through market corrections outperforms the vast majority of active hedge fund managers.

However, it is important to note that buying an index of 500 large cap stocks with retirement funds and a multi-decade time horizon is much different from putting all of one's money into a cryptocurrency that doesn’t pay dividends or even have any intrinsic value.

This is where risk management comes into play. An entire generation of new investors have learned that taking maximum risk is a good thing, and reducing drawdowns is for “paper hands”. The reality is that nothing could be more detrimental to one's longevity and success as an investor.

In a world in which unprecedented events seem to be occurring with increasing regularity, it is more important than ever for market participants to focus on risk management. Without a robust risk management discipline we are increasingly vulnerable to market instability.

"Unprecedented events occur with some regularity, so be prepared."  

~ Seth Klarman, billionaire hedge fund manager

So let’s talk about risk management and some concepts that have served me over the years. The following set of ‘rules’ and principles have helped to keep me in the game during some epic market meltdowns in the last twenty years:

• Limit risk per trade to 1% of account equity. This means that if you have a $300,000 trading account, your max risk per trade is $3,000. If we risk more than 1% per trade, we can very quickly end up having 5%-10% drawdowns in a single day when things go haywire and market volatility expands quickly (like recently).
• A 10% account drawdown is a good orange light warning signal to reassess your trading process and perhaps take a step back from the market until you are seeing things more clearly.
• A 20% account drawdown should be a flashing red light that it’s time to greatly reduce risk, step away from the market, and take some time to figure out what’s not working and how to fix it.
• If it’s a shorter term trade, it must have a stop loss level. Taking trades without stops is probably the best way to ensure that you won’t last long trading markets. You might get away with it for a while, especially in strong uptrending markets, but in the long run the market will turn you upside down and shake-out every last penny in your pockets.
• Be clear on what time frame you’re trading, and set your risk parameters and profit targets according to the time frame and volatility of the market you’re trading. The above risk parameters pertain to short term trading accounts and one of the biggest mistakes I see traders make all the time is confusing time frames and mixing ‘long term’ investment positions with short term trades.
• Create separate accounts for short term trading and longer term investment positions. Don’t confuse the two. Long term is long term, and long term positions are naturally going to be smaller in order to endure the full spectrum of market volatility over time.
• Long term portfolio positions generally shouldn’t exceed 10% of one's long term investment capital. I know some will disagree with this principle. However, my experience in junior miners has forced me to adhere to this rule simply due to the incredible downswings this sector can experience. A 50% share price decline is standard in junior miners. And if we put 50% of our portfolio in a single stock, we are regularly going to have 25%+ portfolio drawdowns.
• Technical analysis is a priceless tool that allows us to check our opinions and biases with what is actually happening in the market. Sometimes the market will confirm what we are thinking, other times it will be sending strong feedback that we are missing something in our analysis. In trading, being early is the same as being wrong.  Even if our analysis and market view proves to be correct eventually, if we are early and bet too big with our position size we may not be around for long enough to end up profiting from our 'correct' analysis.

"The problem in investing, I think, is timing. You may be right. But in the long run, we're all dead. Even if you're right, if it takes 20 years to work out, it can be a disaster."

~ Walter Schloss, investor and fund manager

• Put downside risk and the potential for loss first in your thinking. Once we get clear on the downside risk and embrace the potential that we will lose money, the upside profit potential will take care of itself.
• If you find yourself highly stressed with shallow breathing while you’re trading, that's a good sign you’re probably trading positions that are too large for your risk tolerance. Trade smaller, think more clearly, sleep better.
• Remember that the markets we are trading are basically nothing more than characters on a screen. They are not an extension of our identity or our value as human beings. The more our ego gets wrapped up in our opinions about stocks or markets, the worse our results tend to be as market participants. Less ego, more humility, better results.
• A speculator should be willing to have opinions about a market or a stock, but always be willing to shift that opinion when presented with new information. Strong opinions weakly held.

"Humility is an enormously important quality. You can’t win without it. Survival in the end is where the winners are by definition, and survival begins with humility."

~ Peter Bernstein, economist and financial market historian

Another key aspect of effective risk management is being cognizant of the overall market environment. There are times when taking on more risk is warranted due to the strength of overall market trends, or a unique opportunity in a particular trade thesis/setup. However, there are also times when market conditions are generally unfavorable and the trader is better served by reducing one's overall risk and market activity. Technical analysis can help us to more clearly see the bigger picture while managing risk and avoiding some of the biggest pitfalls.

One of the simplest ways to determine if the market environment is favorable or unfavorable is the positioning and slope of the 50-day and 200-day SMAs. When price is above the 50/200 SMAs and they are sloping higher, the market environment is generally more favorable and trade setups are likely to be more abundant. However, when price is below downward sloping 50/200 SMAs, like the situation we find ourselves in today, the environment is less favorable for most trading styles and overall market risk should be reduced:

SPY (Daily)

Sometimes stepping away can prove to be the strongest decision. The market will always be there when you choose to return.