Trading Risk Management – Rule of Three
Category: Risk Management | Dec 24, 2009 |
Would you like to discover a quick and simple risk management strategy that is easy to apply to any trading plan, and has the potential to vastly improve results? Excellent!
I’m not talking about the placement of stop losses, which is what most people consider as ‘risk management’. Rather, this is a simple tool for managing the risk in your trading business.
Effective trading requires focus and discipline. There are many external factors that can interrupt your focus, and destroy your discipline, such as:
- An unreliable internet connection
- Your charting platform losing its signal
- A knock at the door
- The telephone ringing
- A baby crying
- Hunger
- Noticeably too hot or cold
- Fatigue (hopefully from late night trading study, rather than alcohol and party induced fatigue)
And as if that’s not enough, there are many internal factors that can also interrupt your focus, and destroy your discipline, leading you to make decisions and actions based on emotion, rather than following your documented trading plan. You’ve no doubt experienced some of these already. The internal factors would include things such as:
- Hesitation in entering once price triggers an entry
- Hesitation in exiting when price hits your stop loss
- Doubt about your entry after entering the trade
- Fear of exiting at your stop loss
- Worry about how you will explain another loss to your partner
- Any thought about an early exit of this trade, just to make up for earlier losses
There’s a whole lot more, but hopefully you get the point.
One flaw in many trading plans is the absence of a valid strategy for managing these risks. So, let’s fix that situation.
The problem is, traders have no guidelines as to:
- When the risk justifies us stopping our trading,
- When to just pause trading and manage the issue, or
- When to ignore it and continue trading.
The way I do this is using a very simple risk management strategy developed by Shell, a global group of energy and petrochemical companies. Obviously they didn’t create it for use in trading – I just find that it works really well in this environment. (Yes, I know what you’re thinking – I am a risk management nerd!)
What we need to do is firstly classify your current trading as being in a GREEN, AMBER or RED condition. Think of a set of traffic lights. GREEN indicates that everything is fine. This is the desired trading environment. RED is a compulsory STOP condition. And AMBER is a warning that you need to be prepared to stop.
What I’d like you to consider is documenting any RED conditions within your trading plan. This might include things like:
- An unreliable internet connection
- Your charting platform losing it’s signal (when you have no alternative)
- Fatigue due to less than six hours sleep the night before, or more than four consecutive nights with less than eight hours sleep (customise this for your own requirements)
These are mandatory STOP trading criteria. Alongside each of these risks you need to define the actions you will take. For example, how will you manage your charting platform going down? If you’re a long term trader this might not cause too much stress and may actually be an AMBER rather than RED – your stops may be in the market and you probably have alternative charting options. However if you’re a day-trader operating on small timeframes, this is clearly a RED criteria. You may choose to manage this by contacting your broker by phone and closing out all positions.
So, for each risk we define as a RED, we simply document a procedure to manage that situation. And when one of these conditions emerges while trading, we carry out our procedure, and then stop trading until the condition has gone.
Now, everything else that is not as serious as a RED, but can still influence our trading, is an AMBER. The problem here is, as mentioned before, when does it justify stopping, or when should we just continue with our trading?
The Rule of Three risk management strategy simply states that if you get three or more AMBER conditions then that is also an automatic stop. At that point you can either quit for the day and head for the golf course, or manage your AMBERs back to GREEN and resume trading.
So, if your baby is teething, and just won’t stop crying despite your partners attempts to comfort her, and you just suffered your second loss in a row, and you now find yourself hesitating at an entry trigger – that’s three AMBERs.
STOP TRADING!
Before you continue, make sure you manage your risk back into GREEN, or at least less than three AMBERs. Perhaps take a short break to review your two losses and confirm that the setups were valid, review your trading statistics to confirm that two losses in a row is a normal occurrence, and conduct a short relaxation and visualization session. If you’re braver than I am you might also ask your partner to take the baby out for a drive (ask nicely though!)
If you’re satisfied that you’ve now managed the situation back to less than three AMBERs, or ideally completely back to GREEN, then you’re right to start trading again. Otherwise, take the day off. Sometimes a ‘three AMBER’ complete break from trading is a wise move.
While we all hope that our trading will occur within a completely GREEN environment, life’s just not like that. The Rule of Three risk management strategy gives you a simple guideline for when enough is enough – and you need to either stop completely, or reduce some of the external or internal risks. Try it, and see if it helps in your trading as much as it does in mine.
It’s simple:
- GREEN is GO,
- AMBER is CAUTION and
- RED is STOP, but
- 3 AMBERs are equivalent to a RED. Stop trading, or manage those AMBERs back to GREEN.
Happy (hopefully GREEN) trading,
Lance Beggs
© Copyright 2008. Lance Beggs. All Rights Reserved.
Watch the video related to risk management
Paul Proctor and Richard Hunter, VP Distinguished Analysts of Gartner, discuss ways to avoid costly mistakes in IT Risk Management.
Thank’s
Understanding and allocation of risks involved in any investment or work is called risk management. First, you need to do a thorough study of the subject to understand the risks involved. Then for each risk you choose a way to allocate it such as buying insurance or having some contractual obligations for other parties involved in the work or the investment.
If some competent engineer/analyst has done a FMECA or FMEA, an FTA, and other safety analyses. AND, these analyses have been peer-reviewed and corrected (if necessary), then I see no need for further modelling.
If the system in question is dynamic (changing part types, changing design, changing configuration), then yes, an ongoing model with a full-time or most-time risk manager may be necessary.
Even if the risk manager is not doing his/her job, a continuing model wouldn't be necessary. A simple peer review of the existing models and analyses would be all that is necessary.
.
http://www.meridianlink.com/articles/security_risk.pdf
http://www.netaddiction.com/articles/eia_framework.pdf
http://www.thefreelibrary.com/Internet+Risk+Impact+Summary+Report+for+Q3+2003-a0113377379
First you need to learn to spell interpretation correctly. Mistakes like that in a resume are really damaging.
You may find a course at a community college. I took one from Dun & Bradstreet by correspondence years and years ago and found it quite helpful.
In business, the term operational risk management (ORM) is the oversight of many forms of day-to-day operational risk including the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Operational risk does not include market risk or credit risk.
Good for you. But there is no such thing as MBA in risk management, or MBA in marketing, of MBA in finance. The MBA is a general broad degree covering a wide variety of business issues and training students for careers in managing any area of business up to CEO. MBA students study accounting, finance, marketing, statistics, management, economics, strategy, policy, leadership and similar courses. The MBA was developed because people with technical backgrounds getting promoted into management are not always able to manage, and people in management often don't understand the technical fields they manage. That's why MBA programs prefer students with degrees in other than business and with 2-4 years of work experience. Their graduates learn to manage and can speak the language of the people they manage, whether that is engineering, chemistry, medicine, music, or any other field.
Many MBA programs offer concentrations, but this usually amounts to 2-3 elective courses in a specific field in the second year of the program. So don't worry about a concentration but be careful in choosing the right program. If you find one with Risk Management courses, consider the quality of the school first, and the concentration second.
Before you consider which MBA program is for you, consult the Official MBA Guide, a comprehensive free public service with more than 2,000 MBA programs listed worldwide. It allows you to search for programs by location (US, Europe, Far East, etc.), by concentration (finance, marketing, aviation management, health management, accounting, etc.), by type of program (full-time, distance learning, part-time, etc), and by listing your own criteria and preferences to get a list of universities that satisfy your needs. You can use the Guide to contact schools of your choice, examine their data, visit their web site, and send them pre applications. You can see lists of top 40 schools ranked by starting salaries of graduates, GMAT scores, and other criteria. It's the best service available at http://officialmbaguide.org.
You'd do a lot better researching the general principles of risk management strategy before asking individual insurers (it's a huge subject)
You can read up on various principles through the IAIS which is pretty much the lead organisation in the world for setting requirements for insurers.
http://www.iaisweb.org/index.cfm?pageID=2
Also ..a personal tip …. although obviously rules are different from jurisdiction to jurisdiction, some of the most comprehensive and yet concise I've seen are the Australian ones (they are very hot on risk management in Aus).
You can read the guidance notes here….
http://www.apra.gov.au/General/General-Insurance-PPGs.cfm
That way you can target your questions and get a much better response
What is Quality Assurance?
The answer will be something along the lines of fitness for purpose.
Also, perhaps you could do a bit of research on the Prince2 project methodology…….it covers all of the areas you are interested in.