A truly first-rate book on risk management for the individual trader has yet to be written. In the meantime Michael Toma’s The Risk of Trading: Mastering the Most Important Element in Financial Speculation (Wiley, 2012) helps to fill the void.
If I had to choose the two key sentences in this book they would be: “Risk management is not limiting losses. It is the art of maximizing profits for a given optimal risk.” (p. 173) That is, contrary to commonly-held views, risk management goes far beyond placing stops or calculating position size. It also goes beyond the purely mathematical, even though it would still behoove traders to be familiar with the seminal works of Ralph Vince (The Mathematics of Money Management, 1992) and the many books and papers that followed in a similar vein.
Toma, a corporate risk manager and the author of Trading with Confluence, offers a simple, math-free analysis. (Well, here and there a spreadsheet comes in handy.) He is at his best when discussing how to track performance.
One recommendation that I consider especially sound is that the trader track opportunity risk. “Auditing ‘opportunity risk’ is equally as important as measuring your actual trades. … In all the risks associated with trading, I find opportunity risk, whether in the form of unexecuted trades or pretarget exits, to be the difference between traders who reach that much-talked-about top 10 percent in the profession and those who remain in the novice pool, struggling to keep their heads (and P&L) above water.” (p. 126) If you were presented with a valid trade setup in your plan and you sat on your hands, track that trade. Are you actually skilled at overriding your system or should you, as Toma argues, take advantage of every opportunity that your plan presents?
Toma recommends that every trader construct his own key performance indicator (KPI) dashboard. Keep it simple, sticking to five to eight measurable items initially. And keep it balanced in scope. “The indicators should represent a balanced monitoring synopsis of performance, compliance, and business metrics. A common gap in KPI programs is that it is completely dominant in trade result metrics. A measure that detects rule breaking is far more indicative of trading success than a KPI that measures current win percentage over a small time period.” (p. 133)
A trader’s dashboard metrics could include such items as average number of trades per day, average quantity of shares (or contracts) traded, ratio of trades reaching target vs. trades hitting a stop, trades reaching target vs. total trades, opportunity risk, performance consistency, risk-to-reward ratio, number of days in full compliance, performance edge by setup opportunity, and peak performers by day and time. “Adjust these samples to your liking or create your own key performance indicators. As long as they alert you to areas of development or internal issues that are preventing your success, they truly live up to their ‘key’ performance acronym.” (p. 139) By the way, Toma suggests that updating your dashboard data is better done over the weekend than on a daily basis.
Traders often fall short when it comes to setting stops and targets. Toma proposes that traders use backtested values for MAE and MFE (maximum adverse excursion and maximum favorable excursion), powerful concepts introduced by John Sweeney in Campaign Trading (1996), to “find an area to consider for the initial stop and target. When these levels coincide with multiple layers of support and resistance, then you are trading with a confluence edge, which is the most powerful formula for success.” (pp. 173-74)
The Risk of Trading is a call to arms for the trader who either keeps no trading journal at all or simply records profit and loss. Metrics are critical to success. Just think where Amazon would be today if management didn’t bother to track consumer preferences and left inventory control to chance.