|  MAR 1993

Determining Optimal Risk by Ed Seykota and Dave Druz

Determining Optimal Risk by Ed Seykota and Dave Druz Seasoned traders know the importance of risk management. If you risk little, you win little. If you risk too much, you eventually run to ruin. The optimum, of course, is somewhere in the middle. Here, Ed Seykota of Technical Tools and Dave Druz of Tactical lnvestment Management, using subject matter and materials that they have used in lectures and workshops around the US, present a method to measure risk and return. Placing a trade with a predetermined stop-loss point can be compared to placing a bet: The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure — or heat — from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2% on each of five instrument & has a total heat of 10%, as does a portfolio risking 5% on each of two instruments. Our studies of heat show several factors, which are: 1 Trading systems have an inherent optimal heat. 2 Setting the heat level is far and away more important than fiddling with trade timing parameters. 3 Many traders are unaware of both these factors. COIN FLIPPING One way to understand portfolio heat is to imagine a series of coin flips. Heads, you win two; tails, you lose one is a fair model of good trading. The heat question is: What fixed fraction of your running total stake should you bet on a series of flips?

by Ed Seykota and Dave Druz