Risk, Return and Draw Downs

The subject of today's post is likely one of the more important and misunderstood areas of trading, namely how much is too much to risk on each trade? Also known as bet or position sizing, this key part of a trading system or method will ultimately determine absolute returns and on the flip side, size of draw down and subsequent chance of going bust!
It remains a fact of trading that the two elements of risk and return are linked and actual risk per trade must be thoroughly understood before deciding on how much equity to bet per trade.

When risk per trade, normally expressed as a percentage of equity, increases, so does the return during profitable periods in the market. However, this will make the draw downs larger too. These two sides  of the coin are not linked in a linear fashion. At some point bet size will get so big that the ensuing draw down will put the trader out of business.

Thus it is a vital question to determine what is a reasonable amount to risk on each trade?

The answer to this is not necessarily obvious as another important factor is the order of both winning and losing trades. We Have no way of telling beforehand whether each trade  will have a favourable outcome or not and streaks of both winners and losers are largely random in outcome. We must accept that every trade is isolated from both the previous and subsequent one and no matter how good our system or method, we will have winning and losing runs, which will create a fluctuating equity curve.
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One  way we can quantify this is by looking at data from a trading system and using back testing software, vary the risk per trade, to see what happens to return and draw down.

Consider a trend following system, which trades sixteen commodity markets and over a large data set is profitable, we examine two rolling time periods, when performance was markedly different, first the period 2011-2014, when good trends existed and the model performed very well, then the period 2014-2017 when trends in the markets were scarce. Using the software, we vary the bet size incrementally from 1% to 10% per trade in 1% steps:

During this first  period, the system performed well and we appear to have some great returns, column three, the CAGR, shows annualised returns between 22% and 140% depending on the amount risked  (shown in the first highlighted column). Notice the other marked column shows the associated draw downs, which vary from 15%-98%.

Note what happens as the risk per trade increases: In this period, chosen for the strong trends, as risk per trade increases the returns look very enticing! Who wouldn't want a system making 100+% per year? However even in this favourable time window, the draw downs start to get a little eye watering! Not many professional traders, especially if they are managing client money, will be able to stomach draw downs over 30% and as we see in the draw down column, if you chase a 140% return you have to sit through a 76% draw down. Unlikely in most cases. Bare in mind that you are also risking 9% per trade at this point, an amount which is highly likely to put you out of business, requiring only a run of eight or nine losing trades in a row to drain the account!
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To further illustrate the point, we consider the next rolling time period from 2014-2017, during which trend following systems generally had a very poor spell. We repeat the same exercise, stepping the risk per trade from 1%-10% and see what happens:

This time we see the brutal reality of betting big! During this period where the system performed poorly, anything over 2% put us at risk of going bust. Even a 1% risk per trade shows a hefty 49% draw down. Remember this is the same mechanical trend following system trading the same markets in the same way, just at different times. Your job with this trading system is to take every trade without hesitation and follow the trading signals, irrespective of the outcome. That is how trend following systems normally work and if you had started trading this system in 2014, you would be 49% worse off after three years hard work, whilst betting just 1% per trade. It's a tough game sometimes!

Had you started trading this system in the previous profitable period from 2011, you could have made triple digit gains! This is where luck plays such a large role in trading.
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So, in conclusion, it makes sense to bet small on every trade. Due to the random outcome of each trade and  trading period, betting anything over 2% per trade puts the trader at serious financial risk. Once you start betting bigger, a losing streak will quickly run up draw downs that may not be recoverable. It is worth remembering that a 10% loss  requires an 11.1% return to recover, whereas a 40% loss needs 67% recovery and so on. 

Keeping it small keeps you in the game!