Risk Per Trade in Macro Investing
I have read a few books (and online resources) on macro investing but I still don't have a good grasp on the concept of risk per trade. Could you help me understanding it please? (below are a few thoughts I have on this).
I find the consensus advice from the legends and pros is that that traders should not risk more than 1-2% per trade. However, I am not sure what exactly this number means. I have thought and interpreted this in a few ways:
1) Based on AUM: For instance, if you manage $100 mm, then your gross exposure per trade is $2 mm. Says if you make 10% on that trade then you make $200 m. You will need 100 profitable trades like this to make 20% return pa. I think 100 10% profitable trades per years is not feasible (let alone 100% batting average).
2) Based on required margin to maintain the trade: If you put on an S&P 500 trade, with 2% risk, you can buy 476 ESU7 contract (total exposure of ~$57.5 mm) for a total required margin of ~$2 mm. If the trade goes 5% in the opposite direction, you would lose ~2.9%.
3) Based on some a combination of trade time frame and volatility. For instance, if you put on a short-term trade, says a week, and the median volatility of that security is 6% weekly, you put on a trade size so that at 6% move in the opposite direction, you would lose 2% of your AUM and you are out of the trade. (side note: I calculated a few examples using 2) and 3) and find the total trade exposure are within a reasonable range, could it be the margin requirements take into account of volatility!?).
Thanks gents and happy the Fourth of July!
yes, all of the above. and more.. you can back into risk per trade for #2 - ie. set up your loss including margin to be 2% instead of 2.9%.
3 is more akin to VaR, which is a fine way too
While it's all more art than science, 3 is the more sensible approach (and yes, it has some overlap with 2, since margins are supposed to based on volatility).
Other than that, you need some scope to vary sizing of individual trades based on their perceived attractiveness.
Risk is usually defined by maximum loss not just exposure. For example, if you have a position that is 10% of assets but you set a hard stop at 20% move against you, your risk for that trade is only 2% (provided sufficient consideration for liquidity so you can actually get out at your stop).
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