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.
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?