Risk before return: position sizing, drawdown and survival
Core philosophy
Risk management does not eliminate losses. It prevents one error or one adverse regime from becoming irrecoverable. Survival is a prerequisite for exploiting any genuine edge.
1) Set trade risk before position size
Define a logically valid invalidation distance first, then calculate size from the amount of capital you are willing to risk.
Choosing size first and moving the stop merely to fit a money number reverses the correct logic.
2) Drawdown is asymmetric
A 10% loss requires roughly 11.1% to recover; a 50% loss requires 100%.
3) Look through correlated risk
Three positions are not necessarily three independent risks. Several risk assets exposed to the same liquidity factor can behave like one large trade.
4) Risk of ruin and losing sequences
Even positive-expectancy systems can experience long losing streaks. Excessive sizing increases the probability of reaching a capital level from which practical recovery becomes difficult.
5) Kelly sizing and why caution matters
Kelly provides a growth-optimal framework under specific assumptions, but it is highly sensitive to estimation error. In changing markets, full Kelly can be aggressive; fractional Kelly or explicit risk caps are more robust.
Risk protocol
- Per-trade risk cap
- Portfolio concurrent-risk cap
- Daily/weekly loss budget
- Size reduction after drawdown
- Pause rules for abnormal execution or regime shifts
- No “revenge sizing” after losses
Recommended books
A structured treatment of financial risk.
Advanced treatment of capital growth and sizing.
Takeaway
Professional risk means knowing in advance how much you lose if wrong, how many losses you can survive and when risk must be reduced.