Portfolio Heat An Integral Part Of Risk Management

May 09, 2012 9:52 PM ET
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Brice Hogan and Derek Brown are Co-Founders of CMT Trader a Technical Trader website focusing on using technical trading systems to trade options. Brice and Derek have also worked as stock market and options coaches, educating investors on advanced topics in options like measuring volatility, and the benefits of using technical analysis to signal trade entries and exits. They are active traders, and between the two of them have over 30 years securities industry experience CMT Trader offers a weekly Options Investing video newsletter for $199.00/monthhttp://cmttrader.com/Services.html as well as other investor newsletters to help their subscribers navigate the market Please visit the website for more information on how it can help your trading.

Portfolio Heat is not a professional basketball team it is an essential piece in managing a traders portfolio. In order to be a successful trader we have to be aware of the risks and how it can affect our portfolio. In many ways when we enter positions we have to think what is the worst-case scenario and plan for it.

Portfolio heat is how many potions we have open and the portfolio risk that each trade carries. Lets say for example you have portfolio risk of 1% meaning that if the position you open losses everything only 1% of your portfolio will be lost.

Now lets say we open 5 positions our portfolio heat stands at 5% that is if everything goes belly up we only lose 5% of the portfolio.

If you wanted to open more positions with 5% portfolio heat you would then have to adjust your portfolio risk. In this case if you wanted to establish 10 positions you would have to adjust your portfolio risk downward to .50%

The formula is pretty easy to calculate:

Portfolio risk x Number of positions = Portfolio Heat

The amount of portfolio heat is really dependent upon the trader. For more risk averse traders portfolio heat can come somewhere between 5 to 10%. Especially if you are a new trader it helps to have a lower portfolio heat so you can preserve your capital.

Some more experienced traders can tolerate a higher portfolio heat, mainly because the have more experience managing positions and their systems are more refined, the system they maybe using could have higher winning percentage.

The key with portfolio heat is it's a way to manage your overall portfolio exposure.

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