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.
Most liked posts in thread: Portfolio Heat: will it save your bacon?
Page 1 of 3
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
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
Re-reading Pete's posts, what I'm calling Open Profit-Open risk sounds like what he's calling Portfolio heat (open profits/loss versus current trailing stop).
I try to focus on profit/loss of my trailing stop values rather then get excited if open profit suddenly spikes - its a psychology thing. Its not currently an integral part of my system.
Average holding period is just under 6 months for winners. I'm fussy about entry criteria and prefer to hold on for long term trends rather than jumping in and out a lot. There are tax benefits too if you can't get a nice profit held >12 months. Once the trend has clearly failed, I'm out though.
Page 1 of 3