Trend Following – How Much Equity To Risk Per Trade
In virtually every trading forum you will see the advice offered that you shouldn’t risk much more than 2% of your equity per trade. Unfortunately, most people don’t realize exactly where that figure comes from, or if it is even valid.
The fact is, the amount you risk per trade is dependent upon a few factors…
- The long term per trade expectancy of the strategy or system you are trading
- The compound annual rate of return you are trying to achieve
- The amount of equity in your account
- And how much of a peak to valley drawdown you are able to stomach
For the new trader, it is virtually impossible to get this figured out before you start trading. Until you put your feet to the fire, you won’t know how much volatility you can stomach in order to achieve the rate of return you desire. Money talks…paper trading simply won’t effectively simulate actual trading.
Also, you need to determine what to expect from your system or strategy. This requires significant research and testing. Just as an example, most successful trend following CTAs tend to experience a worst drawdown that is at least double their compound annual growth rate, over a period of at least ten years. Track records under five years are fairly irrelevant for trend followers. This is why when you conduct your research and testing, you really need to go back at least 15 years or more.
The amount of equity in your account will determine the number of markets you can reasonably trade. The smaller your account is, the fewer the markets you can trade, and the greater your risk per trade will be. It is very difficult to limit risk per trade at under 2% with a trend following system if you have an account much under $50,000, except when trading the micro sized contracts.
On the other hand, if you are trading a strategy with a higher percentage of winners where your winners still significantly outweigh your losers, you might want to consider risking more per trade to achieve your desired results.
With that in mind, before you start trading any type of system or strategy, be sure you do your homework and do the appropriate testing on it before you apply some random figure that you read about on the internet or in a magazine.
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