Risk management requires a multi-layered perspective of analysis; on the basis of leverage, individual trade (as determined by our stop), correlation (multiple positions/markets) and portfolio (our worst case scenario of all positions being stopped on our total equity capital). For the purpose of this site, I want to focus on leverage and trade risk, as it fits in with my focus on trading the NQ mini contract.
In trading futures markets we have to be focused on our levered risk at any time. On that basis, I can look at my trading equity in two ways; both nominally and on a margin-to-equity basis to decide how I want to participate as a trader.
Let's look at the nominal approach:
We first determine the nominal value of an NQ contract by taking its most recent closing price and multiplying it by 20 (contract multiplier): 2220 x 20 = $44,400 value/contract. Under the scenario of using say 100% leverage and a 50,000 trading account, we simply divide 50,000/44,400 x 2 (100% leverage) = 2.25 contracts or 2 contracts.
We can modify the nominal leverage of total capital up or down. Let's say I want to increase my equity leverage to 200%. Take 50,000/44,400 x 3 (200% leverage) = 3.38 contracts or 3 contracts/position.
Now, let's look at the margin to equity method:
Say, I want to diversify my investment capital among different assets and that I want 60% exposure to stocks. Taking 60% of my initial capital of 50,000 = $30,000 of exposure. Using the margin to equity method, I use the margin deposit required by the exchange to hold the position as equity. The NQ contract requires 3500 margin deposit and my desired allocation to equities is 30,000. So, 30,000/3500 = 8.57 contracts or 8 contracts of exposure.
If my focus is entirely based on a single strategy, then I can use 100% of my equity in the margin to equity method. So, 50,000/3500 = 14.28 contracts or 14 contracts/trade.
The second critical layer of risk management (and not second in importance) is the individual risk on a per trade basis. Now we have to tie-in the leveraged risk scenario above with our trade risk to discover how much of our equity capital we put at stake. Trade risk is defined by our stop loss: let's say that we are taking 10 NQ points of risk on a single trade. Using the nominal method above and 100% leverage, we have 2 contracts x 10 points of risk x 20 (contract multiplier) = $400 of risk in this trade. This equates to a 0.8% risk of our initial capital. Now, assume that we are using the margin to equity method and a 100% allocation to a single position: 14 contracts x 10 points of risk x 20 (contract multiplier) = $2800 of total risk in this trade. This equates to a 5.6% risk of our initial capital of 50,000.
Now, just because we want to use 100% of our capital in a single position, we don't have to enter all 14 contracts simultaneously. We can scale or pyramid into the position by creating an initial position size that is based on that amount of risk defined by our stop and by our leverage method. We also use our system rules to assess our level of conviction to determine how aggressively we would like to participate.
Let's take the margin to equity method again as our starting example, and using our trading rules we find the market is giving a strong signal on the basis of directional alignment and structure. Now, based on the 3 Day Rolling Pivot Range (our position 'initiator') we have a 25 point rolling stop of risk. By entering all 14 contracts simultaneously we have 14 x 25 x 20 = $7000 of trade risk on the table. That is equivalent to 14% of total equity - way too risky. I might decide to open 6 contracts which reduces total portfolio risk to 6%, still very risky. This might suggest that the trader use the nominal method to open this position. Nonetheless, I would wait for my Rolling Pivot Range to catch up to the price action before entering my second increment. The second increment will always be smaller than my initial position to keep the average cost basis of the trade as low as possible. Let's assume that market moves up a fast 30 points by the end of the first day. Our total portfolio equity has increased by 30 points x 6 contracts x 20 = 3600 to 53,600. We now have to re-adjust the risk of this position basis our new total equity.
