Portfolio Heat: will it save your bacon?

I'm increasingly aware of the need to consider portfolio heat when you hold stocks. So let me set the scene, and then I'll pose some questions to you.

What is Portfolio Heat?
If you hold 10 shares, each with stop-losses and the most you'll lose is 1% per share, then if the market nosedives you could lose 10% of your total portfolio. Your portfolio heat is 10%.

Who understands this?
Traders. By contrast, investors will usually limit their risk by diversifying across a range of shares (share specific risk), by then won't protect themselves against whole market risk. "Time in the market" approach.

I'm of the opinion that if you set stop-losses (or price related exits) on individual shares at all, then you should also be factoring in your total market exposure. These concepts go hand-in-hand.

Questions:

Can we agree on the definition?
@peter2 uses two terms: Portfolio heat is your total money at risk in the market, and Capital at Risk assumes that whenever a position's stop reaches break even or above, that money is now risk free (at least I think that's his definition).

However, when I google "portfolio heat", I see some commentators who exclude positions that are above BE, and others who include them. There doesn't seem to be a consensus. How do you people at ASF define portfolio heat? And if you include all open positions, what term do you give to the risk where you exclude BE positions?

What do you do with your cash?
Portfolio heat "theory" has you setting a limit on your amount at risk, say 5%, 10%, etc. Once a position moves past break even, you can then open a new position. But in the meantime, you've got all this cash waiting there. So what do you do with it?

1) The most obvious thing is to keep as cash (say in a HISA, in AAA ETF etc) OR
2) You could park your cash in less volatile securities, such as bonds. But given that the value of bonds can drop, wouldn't you also have to factor your bond exposure into your total portfolio heat? OR
3) Park your cash in an index fund. This is crazy talk if you're trying to protect against market crashes. However, if you asking yourself: "Does my new trading system outperform the index in practice? I don't know."; then hedging your trading system risk by keeping the unallocated cash in an index fund, could make sense.

So what's the best place to store you cash as you're waiting for your portfolio heat to cool down to open your next position?

I keep my unused cash in HISA and only plan to move money into Gold related or Bonds type of investments if I don't need to take it back in the medium to longer term. I don't see the added complication of short term gains/losses from Gold/Bonds adding any value.

So money transferred between HISA and stock broking account for share trading. Longer term investments such as Gold/Bonds to be left alone.

That part is easy.

What's not so easy is to answer the thread question regarding portfolio heat. I don't have an exact answer but I also limit damage by scaling into the market rather than being fully invested at the first sign of bullish sign after a sell off. When I say 'scale in' I mean buy a few stocks at a time and allow them to rise with the market for a bit before buying more stocks and so forth. Yes, that means I am very late into a bull market before fully invested but I tend to tread on the cautious side.

aus_trader said:

I keep my unused cash in HISA and only plan to move money into Gold related or Bonds type of investments if I don't need to take it back in the medium to longer term. I don't see the added complication of short term gains/losses from Gold/Bonds adding any value.

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That make sense.

aus_trader said:

I don't have an exact answer but I also limit damage by scaling into the market rather than being fully invested at the first sign of bullish sign after a sell off. When I say 'scale in' I mean buy a few stocks at a time and allow them to rise with the market for a bit before buying more stocks and so forth.

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That's in keeping with the principles of portfolio heat: make your existing shares in the market become profitable before putting in new money. Particularly in a high volatility market, that's an excellent way of protecting yourself.

aus_trader said:

Yes, that means I am very late into a bull market before fully invested but I tend to tread on the cautious side.

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That is the cost, for sure. People will quote statistics like "the market made most of its gains in just 4 days. If you weren't in, you missed out". So it's definitely a risk mitigation vs potential reward equation here. The other side of that coin is where the market starts to recover...but it's fake...and has another drop. A cautious investor, like yourself, wouldn't have that many positions at that point, anyway.

Zaxon said:

I'm increasingly aware of the need to consider portfolio heat when you hold stocks. So let me set the scene, and then I'll pose some questions to you.

Questions:

Can we agree on the definition?
@peter2 uses two terms: Portfolio heat is your total money at risk in the market, and Capital at Risk assumes that whenever a position's stop reaches break even or above, that money is now risk free (at least I think that's his definition).

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I use these two in my trading and Portfolio Heat is your open exposure to the market. The greater the gap between price and your trailing stop, the higher the Heat (more open profits can be lost in a downswing to your stop). As prices fall and close in on your TS, the smaller the Heat. This doesnt factor in if your trades are in the black or in the red.

I always take Capital At Risk is my OPEN capital position +cash; essentially my total open exposure to the market regardless of if I'm in the black or not, PLUS cash position.

Someone might adjust their trailing stops, as market conditions dictate, to maintain their portfolio heat tolerance. A real example of this might be that your current heat level won't allow you to take another position (or perhaps force you to take a reduced position). Or even that you may need to aggressively tighten stops to reduce your heat to such an extent that you can now place a new open position in the market.

$20shoes said:

I use these two in my trading and Portfolio Heat is your open exposure to the market. The greater the gap between price and your trailing stop, the higher the Heat (more open profits can be lost in a downswing to your stop). As prices fall and close in on your TS, the smaller the Heat. This doesnt factor in if your trades are in the black or in the red.

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Interesting. So you share the same definition of Portfolio Heat: the risk of all open positions, but you have a different definition of Capital at Risk. I'm not surprised. Google "capital at risk", and everyone uses it informally to mean whatever they want. Do you have a term for portfolio heat - positions above break even?

It's not a relevant concept to me, as I guess I consider my capital 100% at risk, however I have always heard traders refer to portfolio heat as the current aggregate risk of total capital based on current stop levels.
Simply, if you are risking 2% of capital per trade and you have 5 trades open, your portfolio heat is 10%. This is continually monitored to keep trades within your desirable portfolio heat.

It's another area for testing - i.e. the same system (entry, stop and exit rules) will produce different results based on portfolio heat.

Portfolio heat is a term that represents the downside exposure of your portfolio. As systematic mentions it could be 100% as the market can close at any time. Yes, the ASX has closed for short periods of time and the US markets closed for a few days after the 9/11 terrorist attack.

The amount of downside exposure that we select is an arbitrary amount because we can never know what our actual selling price will be. In periods of increased volatility prices can drop below our exit trigger and combined with thin bid volume we may realise a much bigger loss than planned.

It's important to know two things about you and your portfolio heat.
(i) What's your own risk tolerance? How much downside exposure are you comfortable with?
Individual shares and the whole market can drop quickly.

(ii) How much portfolio heat does your system need to operate effectively?
If you're uncomfortable with the amount then it's highly likely that you won't allow the system to operate normally and you'll get sub-standard performance. You''ll blame the system but it'll be your fault.

edit: Whatever level of downside exposure (portfolio heat) that you select, be prepared to experience it multiple times during your trading/investment journey.

peter2 said:

Portfolio heat is a term that represents the downside exposure of your portfolio. As systematic mentions it could be 100% as the market can close at any time. The amount of downside exposure that we select is an arbitrary amount because we can never know what our actual selling price will be. In periods of increased volatility prices can drop below our exit trigger and combined with thin bid volume we may realise a much bigger loss than planned.

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This comes from your post. How are the Capital at Risk and Total Portfolio Heat percentages calculated here?

From the pic posted above.

Portfolio heat is the sum of open EOD P&L - current trailing stop (exit stop) for all trades.
ie (0.6-0.5)+(1.7-0.3)+(0.4-0)+(0.6-0)+ . . . = 4.1% (= Total downside exposure)

Capital at risk is the sum of all trades where there's still some original capital at risk.
ie 0.5+0.9+0.7+0.6 = 2.7% (four trades at the bottom of the table).
The cap risk limit in the pic is 5% so that leaves 2.3% to use. This means I could start another 3 trades risking 0.8% each.

Once a trade has it's exit stop above BE there's no initial capital at risk (unless there's a huge gap down).
I use the Capital at risk parameter to control the number of trades that I start. It's easy to get carried away by all the buy signals and end up starting too many trades at a time when it would be wiser to be cautious. This is one of the modifications I use to avoid a 10% DD when using a system that has regular 20% DDs. Other modifications include the application of a market filter and some active management guidelines

peter2 said:

From the pic posted above.

Portfolio heat is the sum of open EOD P&L - current trailing stop (exit stop) for all trades.
ie (0.6-0.5)+(1.7-0.3)+(0.4-0)+(0.6-0)+ . . . = 4.1% (= Total downside exposure)

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Interesting. I'll do some math to try and replicate your figures.

Using DTL from your above table, I get

or 9.1% profit.

Your table has 0.6% profit for this entry (DTL). I'm therefore assuming that is the 9.1% / initial portfolio value (or something like that). Digging through your P2 Weekly thread, I see you started out with $222k.

So redoing the math, (I don't know whether you're still using the original $222k or if you're using the current portfolio net worth, but I'll go with the original for now) we get:



which agrees with your 0.6% in your table. Is that your math?

Looks like you've reverse engineered that perfectly.

Will knowing your portfolio heat, save your bacon? NO
Portfolio heat is the downside exposure that you're comfortable with in order to earn the rewards you seek.
Most people overestimate the amount of downside exposure that they're really comfortable with. Think back a few days, did you worry when the market fell solidly for two days? How will you feel if the market continues to fall? A few people commented on how they were going to handle their portfolios after the second down day. Were they worried? No, because they've seen it before and expect it to happen.

Whenever I start a new trading plan the first question I ask is what is the expected downside exposure for this plan? Can I handle that? Will I continue to stick to the plan when I find myself losing?

Then, I consider, is the reward worth it?

Alrighty then. I will convert this into formula type language that could be useful when putting together a spreadsheet, etc.

Portfolio Heat (per share) =
((share_price - stop_loss_price) * num_units_held) / total_portfolio_value * 100

Capital at Risk (per share) =
if (stop_loss_price >= entry_price) then 0
else ((entry_price - stop_loss_price) * num_units_held) / total_portfolio_value * 100

Chris Weston

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‏ @ChrisWeston_PS

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Aug 7




I'll be holding a webinar this weekend on using implied volatility (over realised vol) to define our risk. Feel free to sign up, I've added the pitch on content and the spreadsheet which will be sent out each week. Sign up here

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https://www.traderfest2019.com/home?utm_medium=social&utm_source=twitter&utm_campaign=trader-fest

Portfolio heat, or the sum of profits above stop loss for all your holdings, is also useful to help your mindset around monitoring open profits. I've found focusing on open profit adjusted for "open risk" helps me deal with the inevitable rapid market falls into drawdown. As a systematic trend trader, its no use getting excited over long periods of climbing profits if you blow your cool after a few down days.

Its no fun seeing open profit evaporate quickly, but they're never really your profits until you book them and you usually shouldn't be doing that until price closes below trailing stops (thinking weekly trend following here).

Newt said:

Portfolio heat, or the sum of profits above stop loss for all your holdings, is also useful to help your mindset around monitoring open profits. I've found focusing on open profit adjusted for "open risk" helps me deal with the inevitable rapid market falls into drawdown.

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"profit adjust for open risk" - can you explain what you mean here? And what percentage portfolio heat do you allow in your portfolio?

Newt said:

As a systematic trend trader, its no use getting excited over long periods of climbing profits if you blow your cool after a few down days.
Its no fun seeing open profit evaporate quickly, but they're never really your profits until you book them and you usually shouldn't be doing that until price closes below trailing stops

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Agreed. It's very easy to give those profits back. And the market doesn't even have to go down. If it goes sideways for a while, and the market is volatile enough, you can get whipsawed out.

Newt said:

(thinking weekly trend following here).

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Weekly, OK. What's your average holding period?

I think portfolio heat has to be taken in consideration with the type of risk management you are using.

Is your stock selection governed by max stocks you can hold or max risk to Capital you are trading.
The way I see it with Peter2 if I'm correct he will continue to add stocks while his portfolio heat remains under certain %. So he will in theory have no limit to the number of stocks he can hold in a bull market the way I see it.

willoneau said:

The way I see it with Peter2 if I'm correct he will continue to add stocks while his portfolio heat remains under certain %. So he will in theory have no limit to the number of stocks he can hold in a bull market the way I see it.

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Not quite. Portfolio heat ignores whether a position is in profit or not. So if you factor that in, you'll hit a limit fairly quickly. Capital at risk allows you to remove any portfolio heat that is in profit. So as each position becomes entirely profit, you just keep adding more.

Why does portfolio heat ignore if a position is in profit?
What is it measuring?
If all your positions are in profit and your trailing stop is above your entry price what is your portfolio heat?
are you including paper profits as capital also at risk?