 it’s  prettyimportant for you to challenge yourself. You really have no choice but totry  to  become  better  at  this  game,  as  you  are  not  likely  to  remain  at  thesame  level  of  investment  competency  for  very  long.  By  definition,  eitheryour skill set is improving or it is eroding. If you want to succeed, you mustcontinually push yourself. 
Even  if  you  are  making  more  money  than  you  ever  imagined  and/orhave  accumulated  more  capital  than  you  can  envision  spending,  if  youwish to continue on in the business of trading, it will be necessary to reachfor performance objectives that are beyond your grasp, if nothing else asa  means  of  ensuring  that  you  don’t  fall  into  a  comfort  zone  that  may  beharmful to your longevity in the markets. 
How  does  the  setting  of  an  ambitious  performance  objective  helpensure that your trading skills continue to improve, as opposed to erode?Among other factors, the mere process of setting the high target will forceyou,  if  you  are  not  given  to  introspection,  to  carefully  examine  everyaspect of your trading in order to identify potential areas of improvement.In particular, if you are comfortable that in a given cycle you are likely tomake $X and then set your target level of return to, say, between 125 per-cent and 150 percent of $X, you will simply not have any alternative otherthan to take a look at every individual associated subprocess in order tofind sources of potential efficiency improvement and scalability.
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Indeed,  while  the  market  superstars  I  have  known  are  as  diverse  agroup as the United Nations General Assembly, they all have in commonthe setting of aggressive performance goals. At least once a year (more fre-quently  if  necessary),  they  use  the  exercise  of  setting  the  optimal  targetreturn to undertake a full-scale evaluation of their programs and to makewhatever  changes  they  deem  necessary  to  help  them  achieve  their  loftyobjectives.  Again,  the  underlying  objective  here  is  to  continue  your  pro-fessional growth so as not to fall into a trap of stagnation that can lead toregressive behavior and deteriorating performance.
How  does  this  reengineering  process  occur?  What  forms  can  itassume? Obviously, this will vary from situation to situation. Following isa list of four analytical steps that you might begin to take, which may pro-vide  great  insights  into  the  best  means  of  achieving  goals  that  you  maybelieve are currently outside your grasp.
1. Critical  Self-Assessment  of  Performance  during  Previous  Cycle.The  first  step  in  the  evaluation  process  should  be  a  review  of  yourperformance over the recent past. Here, you should begin by lookingat  everything  that  touches  your  trading/investing  process,  from  thequality of market opportunities to the physical environment in whichyou are operating. How were the markets last year? Were you satis-fied  with  your  performance  in  light  of  these  conditions?  Whichopportunities  did  you  make  the  most  of  and  which  did  you  miss?What component of your performance can you honestly attribute togood luck, to bad luck? Given all of this, what would you have donedifferently?
2. Review of Current Conditions. The next step is to take a very closelook at the current characteristics of your trading environment. Hereagain it is important to evaluate both market-based factors and situa-tion-specific factors. Note that the purpose in doing so is to create anobjective and realistic backdrop for your strategic market initiatives,not to force yourself to generate a “market call.” If your market call isgood  enough,  you  will  need  little  in  the  way  of  trading  technique  inorder to be successful; and you will not find very much in this book orany  other  trading  manual  that  would  create  much  of  an  additionalimpact. Most of us are weak in this area, and we know it; so it’s impor-tant  to  develop  as  careful  an  understanding  of  the  prevailing  condi-tions as is practical.
Focus  here  on  qualitative  factors.  Are  the  markets  trending  orchoppy?  What  types  of  participants  are  increasing  their  activities?What types are reducing capital usage or bailing out altogether? Howis  all  of  this  impacting  the  market’s  liquidity  and  volatility?  Answerthese questions as objectively as possible. Now, try to assess how the
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associated  answers  are  likely  to  present  themselves—in  the  form  ofopportunities and obstacles to optimal performance.
It is also important to review the more immediate external factorsassociated with your trading. How comfortable are you in your physi-cal trading environment? How is your relationship with those immedi-ately around you and with your supervisor or capital provider? Whatare the best and the worst elements of this setting, in terms of associ-ated prospects for maximizing your performance?
3. Formulating an Action Plan. Once you have completed the reviewof recent performance and current external environment, you are in avery strong position to figure out the adjustments necessary for you tooperate  on  the  higher  plateau  that  the  optimal  target  return  conceptdemands. If all is going well, the key factor here might be an increaseof your trading size, intensity level, and/or support resources. If, how-ever, you have experienced a recent history of trading at levels belowyour optimal expectations, other more rudimentary changes may be inorder. For example, you may have to commit to structural changes inyour trading behavior (a concept we will discuss in further detail), toa  rethinking  of  your  day-to-day  operating  modes,  or  to  other  similaradjustments. Maybe you are simply not working hard enough. Maybeyou’re overdoing it. Whatever the case may be, it will be up to you toidentify  the  opportunities  for  improved  performance,  to  formulate  aplan, and to put it into action.
Finally,  with  respect  to  optimal  target  return,  I  should  mentionthat in some cases this figure may justifiably be set at levels below his-torical  performance.  This  would  be  particularly  true  in  cases  whererecent returns have been suboptimal and/or erratic or where a trader’smarket environment has changed sufficiently to warrant a downgradeof expectations. The point is to identify a performance target level thatwill take you out of the zone of comfort and into that of challenge andto build your trading program around this objective.
4. Masters  and  Their  Master  Plans.
I’ve  actually  been  amazed  at  theeffort  that  I’ve  seen  superstar  traders  put  into  this  goal-setting  busi-ness. After awhile, it started to make more and more sense. Most ofthem are introspective by nature and are always tinkering with variousaspects of their portfolio approach. However, these efforts are minorcompared  to  the  all-encompassing,  top-to-bottom  analysis  that  takesplace in very solemn fashion for nearly all of these guys at the end ofeach  year.  While  this  analysis  is  typically  very  scientific,  the  goal-setting part of it is often not. For one thing, the figures they set tend tobe positively astronomical. For another, the actual numbers at whichthey  arrive  have  a  ritualistic  quality  to  them  that  varies  in  its  originfrom  one  to  the  next.  One  guy  might  like  nice  round  figures,  so  his
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targets  always  have  multiple  zeros  at  the  end.  Another  trader  I’veobserved adds the amount he’d like to give to charity (increasing eachyear at an increasing rate) to the amount he anticipates his wife willspend (rate of acceleration even higher still) to determine the amounthe  needs  to  make.  Sometimes,  if  he  meets  or  exceeds  his  revenuepace, he has been known to prod his wife to spend even more so thebar can be set even higher.
Once  the  superstars  have  the  appropriate  number  in  mind,  theyhave to figure out how to get there, and this involves focusing on ques-tions like: How good are markets likely to be next year, opportunity-wise?  Where  are  these  opportunities  likely  to  be?  How  do  I  need  tochange my trading style to capture them? What adjustments do I needin terms of my support resources? What trading sizes will work best inthese markets? How can I adjust my work habits to help achieve mygoals?
I’ve  seen  this  analysis  process  yield  amazing  results,  even  when  thetrader  in  question,  as  often  happens,  failed  to  reach  his  or  her  targetreturns  at  the  end  of  the  period.  It’s  taken  me  awhile,  but  I’m  now  con-vinced that the exercise is a worthwhile one.
It all kind of reminds me of what I believe artists must do to sustaintheir relevance. Whether it be Bowie and Iggy Pop migrating to Berlin inthe  mid-1970s  to  record  astonishing  albums  behind  the  Iron  Curtain,  orJohn Lennon breaking up the Beatles at their creative peak, or Vincent vanGogh  abandoning  the  comfort  of  his  artist’s  community  in  Paris  only  toburn  his  brains  out  with  badly  made  absinthe  in  the  bleeding  hot  sun  ofArles,  intellectual  excellence  can  only  be  achieved  through  continuousevolution. Guard against getting too comfortable in the markets; like thewilderness itself, the creed of “adapt or die” prevails.
NOMINAL TARGET RETURN
As important as it is to set an optimal target return, it is equally importantto set a minimum performance target that represents the lower bound ofacceptability. In this case, instead of targeting a performance objective thatis geared toward challenge and development, you want to set a figure thatis at a level entirely within your comfort zone. The main reason for this isthat  I  want  you  to  think  of  the  nominal  target  return  as  a  benchmark,which, if you fail to reach it, will cause you to acknowledge that some ele-ment of your portfolio strategy is not working. In turn, this will force youto review your entire portfolio management environment, this time with an
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eye toward either fixing what’s broke or scaling back your expectations, orsome combination of the two.
For certain professional traders (particularly those operating in formalfinancial  institutions),  this  figure  might  be  tied  to  your  budget  revenues,though I am hesitant to be too formulaic in this regard as the relationshipbetween budget revenues and nominal targets will vary from situation tosituation. In some cases, trading managers will take the incredibly scien-tific approach of setting their budget revenues at an arbitrary but signifi-cant percentage above last year’s performance, oftentimes without givingdue  consideration  (or,  for  that  matter,  consideration  of  any  kind)  to  anyobstacles that may render such an objective unrealistic or even irrespon-sible. In other cases, management may set the budget bar too low, prefer-ring  the  somewhat  illusory  comfort  of  knowing  that  they  will  meet  orexceed this target under all but the worst foreseeable market conditions.In any event, while you certainly will want to be mindful of the budgetaryprocess  in  establishing  your  nominal  targets,  you  should  not  allow  the(potentially irrational) budgetary process of your firm to interfere with theprocess of carefully and objectively determining your nominal profit/loss(P/L) target.
If you are operating outside the framework of a professional tradingorganization,  you  will  have  more  freedom  to  establish  a  rational  lower-bound return target. However, I encourage all free agents to go throughthe  process  in  a  fairly  rigorous  fashion  nevertheless.  While  it  will  betempting to tie this figure to such nonmarket factors as meeting minimumspendable  income  levels,  I  suggest  that  you  instead  orient  the  goalentirely toward issues that pertain directly to your trading. Make a realis-tic assessment of all aspects of your portfolio management environment,including  the  markets,  your  modes  of  execution,  and  financial  con-straints. Then ask yourself the following question: “Operating within theconditions/constraints  that  I  currently  face,  what  is  the  minimum  per-formance  that  I  would  consider  satisfactory?”  Understand  that  if  youdon’t reach this threshold, certain adjustments are in order. It’s halftime,you’re down by 10, and your matchup zone just ain’t working. Number 43is lighting you up. If you’re going to win the game, you better try a box-and-one.
By doing this, you stand to accomplish a number of objectives. First,the review process will force you toward the types of sound trading habitsthat we will continue to stress as the difference between success and fail-ure in many circumstances. In addition, by committing to realistic minimalreturn objectives, you will impose a level of objectivity on your trading thatI believe separates the highly successful traders from the rest of the crowd.Absent this kind of thought process, it will be easy for you to evaluate anysuboptimal interval of performance, identify some related external factors
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as the source of your trouble, and happily forgive yourself any transgres-sions  that  you  may  have  contributed  to  the  breakdown.  However,  if  yourise above this kind of wishful thinking, you will place yourself in a posi-tion of control that, as I have seen time and time again, articulates itself inthe form of a fatter bottom line.
Finally, this type of analysis will be invaluable to the health and well-being of anyone whose best trading strategy is to get out of the marketsaltogether (and, sadly, there are many of us out there). If you are consis-tently failing to meet what you have objectively set as minimally accept-able return goals, it becomes relatively easy to start to quantify the cost ofcontinuing on, as measured in terms of mental/physical health, lost oppor-tunity to devote your energies more effectively elsewhere, actual financialexpense, and so on, and to walk away when these costs become prohibi-tive. Conversely, I find that those without a formal program of this type runthe risk of falling into a pattern of perpetuated failure until the cold, hardrealities of the financial marketplace take the timing of the exit decisionout of their hands.
STOP-OUT LEVEL
In addition to casting our sights to the heavens, Browning also warns usabout “hearts, how shall I say, too soon made glad” stating (in My LastDuchess), “I gave commands; Then all smiles stopped together.”1 Recall-ing this, our task of establishing performance parameters simply cannotbe considered complete until we address the issue of maximum tolera-ble  loss.  The  hard  fact  is  that  this  is  the  most  important  performanceparameter of them all, and one that all portfolio managers ignore at theirperil.
Think of it in this way: The business of trading is rooted in the trade-offs between risk and reward. From this perspective, it is perhaps not anexaggeration to characterize risk as “the currency of trading.” And what isrisk  other  than  the  propensity  for  a  given  situation  to  generate  negativeoutcomes?  Each  trading  account  has  (explicitly  or  implicitly)  a  finiteamount of this currency, and it is vital to manage portfolio affairs in sucha way that respects this resource constraint. Moreover, while the amountof risk that a given trader can responsibly assume has absolute boundaries(expressed, typically, in financial terms), within these boundaries, it is usu-ally  within  the  control  of  the  individual  to  set  his  or  her  individual  risktolerance at levels that are likely to reach these boundaries or to exceed
1Browning, in addition to being righteous, was quite prolific.
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them  by  some  measure,  or  to  fall  somewhere  within  them.  The  efficientuse of economic stop-outs involves setting your loss-assumption toleranceat  manageable  levels  that  will  afford  you  much  greater  control  over  thebroad and diverse set of circumstances that you are likely to confront overthe course of your trading career.
Of course, the specific level of acceptable maximum loss will vary,in  both  absolute  and  percentage  terms,  from  account  to  account,depending  on  such  factors  as  the  professional  nature  of  your  tradingactivities,  the  source  of  your  funding,  and  the  volatility  characteristicsof  the  markets  in  which  you  operate.  For  starters,  virtually  all  profes-sional  traders  being  funded  by  financial  institutions  will  be  assignedsuch a “risk capital” number, which should be subject to negotiation ona year-to-year basis. I encourage you to negotiate this parameter aggres-sively,  bearing  in  mind  that  while  other  limits  may  be  imposed  on  you(e.g.,  cash/working  capital  constraints  and  position-size  restrictions),it is  the  amount  of  loss  your  funding  institution  is  willing  to  under-write that  will  determine,  more  than  any  other  single  factor,  yourmoney-making capacity.
Well-run trading businesses with enlightened risk management struc-tures  may  offer  rationally  constructed  risk-capital  allocations  based  onsuch  factors  as  historical  performance,  market  liquidity  characteristics,and internal rate of return targets (both raw and risk-adjusted). However,my experience is that such well-ordered policy structures are the excep-tion. More often than not, the risk-capital/stop-out levels that are imposedon you will bear only incidental resemblance to the underlying economicsof your trading environment. For example, many levels will be based onelaborate  stress  tests,  using  historical,  worst-case  scenarios  as  the  basisfor setting loss limits. In addition to the sheer divergence from market real-ities that is implicit in this approach, such methodologies often miss themore subtle components of exposure that may cause more actual revenuedamage  than  that  caused  by  events  that  have  a  statistical  probability  ofrecurrence, say, once in a century.
Under  these  circumstances,  you  may  find  yourself  in  the  frustratingsituation of having to manage to limit structures that significantly diminishyour ability to deliver risk-adjusted return and, in some cases, may actuallyprovide incentive to make suboptimal risk-reward decisions. This is indeedunfortunate, and any associated frustration you feel is certainly justified.However, it would be a serious mistake to allow this to interfere with cre-ating the most efficient portfolio parameters that you can possibly devise,given  the  constraints  you  face.  I  encourage  you  to  create  your  own  riskmodel and to identify a worst-case acceptable-loss level that would workbest for your specific situation, absent the institutional guidelines imposedon you. Of course, since you won’t be able to avoid the institutional limits,
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your  own  rules  will  have  to  devise  a  system  that  will  give  you  what  youneed but keep you out of trouble with your management. If you can threadthis  needle,  you  stand  the  best  chance  of  identifying  the  most  favorabletrading  program  available  to  you,  given  those  elements  of  your  environ-ment that are beyond your power to control.
RISK CONTROL FROM A CONTINENTAL PERSPECTIVE (PART 1)
Let’s not pretend that a topic such as risk management is exempt from biasesemanating from non-economic issues, ranging from internal/enterprise factorsto  deeply  embedded  elements  of  culture.  For  example,  a  bank’s  policies  arealmost  sure  to  differ  from  those  of,  say,  a  hedge  fund.  Further,  a  Europeanentity is going to look at the subject differently than a U.S. firm would. Becausethese  points  are  important,  I  have  framed  a  hypothetical  sequence  from  theperspective of a French bank, which bears only incidental resemblance to myactual  experiences  in  the  French  banking  system,  because  I  believe  that  itoffers some interesting insights into the manner in which risk judgments canbe driven by a multitude of factors, some of which may not jibe with the criti-cal objective of generating returns while preserving capital.
The first thing you need to know about the French, as they will be only tooglad to tell you, is that their country boasts some of the greatest mathemati-cians  in  modern  history—from  Descartes  to  Fermat.  In  part  for  this  reason,they take great and justifiable pride in their ability to apply quantitative mod-els  to  financial  problem  solving,  as  produced  almost  exclusively  by  the  bestand the brightest of engineers from its leading polytechnical institute (itself theacademic home to the crème de la crème of quantitative practitioners).
It is possible under these circumstances to create risk models that fail tosimulate forests due to overabundance of trees. Consider, if you will, a hypo-thetical limit-setting methodology used by one French trading institution thatwas thought to convey such a market advantage that the company in ques-tion was afraid to provide details of the models to anyone—including thosewhose  job  it  was  to  implement  the  system  and  monitor  associated  compli-ance. In our hypothetical example, the methodology, software, and supportsystems were officially assigned the title of Douce Machine (Soft Machine) ina tribute to both the William Boroughs novel and the avant garde British rockband that took its name (most of the risk dudes in this bank, and even someof  its  senior  management,  were  righteously  erudite).  Then  came  the  hardpart: actually putting to good use a system whose components weren’t wellunderstood  by  anyone  operating  under  its  guidelines.  This  was  a  painfulprocess  for  all  and,  as  I  understand  it,  remains  painful  to  this  day.  At  onepoint, some insiders weren’t quite sure if its architects themselves understood
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what they had built; but they quickly dismissed this suspicion on the basisthat its designers were, after all, polytechnicians and were thus incapable ofhuman failings of this kind. They ended up concluding that there was simplytoo  much  at  stake  in  terms  of  proprietary  intellectual  capital  to  clue  in  thenonnative employees of the firm as to what they were trying to accomplishand how they were trying to accomplish it.
It  was  very  interesting  to  watch  what  happened  from  there.  The  besttraders and trading groups established their own risk criteria in a manner thatharmonized the Douce Machine with pricing patterns that were actually occur-ring  in  the  marketplace.  Those  that  couldn’t  pull  off  this  trick  were  alwaysfrustrated, and often unprofitable. They would routinely blow limits on posi-tions they swore were risk-neutral and often had to liquidate under conditionsof  market  duress.  When  many  of  these  individuals  and  groups  found  othermeans  of  employment,  the  brilliance  of  Projet  Boitte  Noire finally  revealeditself. It was one of the greatest trading-desk headcount-reduction programsever implemented.
For  institutional  traders  fortunate  enough  to  operate  under  morerational risk management regimes, it is nevertheless useful to go throughthe exercise of identifying a maximum tolerable loss that works best foryou, which oftentimes may be less than the actual risk-taking capacity allo-cated to you by your funding organization. One way of doing this is to setstop-out levels for shorter time increments than those set by your fundinginstitution. For example, your primary risk guideline might be a liquidationtrigger  at,  say,  down  15%  of  your  working  capital,  as  reset  on  an  annualbasis. You may find it most effective to translate this into a self-imposed 1%stop-out level each month. This will place you well within the parametersset by the organization and might offer you additional peace of mind, in thesense that you have set aside a risk capital reserve, which will hopefullyaccumulate  over  time  and  reduce  the  likelihood  of  a  firm-imposedliquidation.
The task of setting the stop-out threshold if you are funding your ownportfolio is one with characteristics that are very different from those setfor  an  institutional  portfolio.  Ideally,  you  will  also  set  this  figure  onthe basis of a thorough review of your market environment, and withinboundaries that don’t approach constraints such as the amount of wealthyou possess or (worse yet) the sum of your wealth and your borrowingcapacity.  Instead,  you  should  risk  only  discretionary capital,  that  is,those  financial  resources  at  your  disposal  that  you  can  afford  to  losewithout  significant  sacrifice  to  the  critical  elements  of  your  lifestyle  orlong-term  financial  well-being  (mortgage,  tuition,  car  payment,  retire-ment nest egg, etc.).
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In fact, other than as part of an efficiently adapted wealth-managementprogram, I can think of no good reason to ever put core personal financialresources at risk in the marketplace. I do, however, know of a number ofbad reasons, and the first that comes to mind is because you are convincedof  the  success  of  your  trading  model.  If  your  system  is  that  good,  then  Iwould argue that time is on your side. Stick with smaller bets, and let yourtransaction size accumulate, along with your profits. If you can’t afford towait,  it  must  only  mean  that  you  don’t  expect  the  opportunities  you  areseeing to recur (in which case, I question why you are making such a com-mitment to trading in the first place); that you have access to informationthat  may  be  illegal  to  use  in  the  markets;  or  that  you  are  trading  from  aposition of financial disadvantage, which is a likely recipe for disaster inalmost all circumstances.
In addition to staying within a loss threshold that will keep you out ofthe poorhouse (and, perhaps, also the bighouse, when the feds find out; orthe doghouse, when your spouse catches on), there are a number of fac-tors that you should consider in setting your maximum-loss threshold. Inparticular,  I  recommend  sitting  down  and  performing  the  same  type  ofreview  of  markets,  trading  modes,  and  so  on,  that  a  professional  institu-tional  trader  conducts.  Have  market  conditions  improved  or  worsened?How much time and energy can you devote to trading? Are you set up tomaximize  information  flow  and  execution  efficiency?  Once  you  haveanswered these questions and applied them through the filter of your risktolerance, the final piece of the puzzle will in most cases reside in your psy-che. You should set your stop-out level at a figure that is large enough foryou to feel that you have given your trading a fair shot but that falls shortof the point where reaching it becomes demoralizing or debilitating.
Whatever figure you finally identify as your largest acceptable loss, themost important thing is to live within this limit and to commit to a full-scaleportfolio  liquidation  if  you  are  unable  to  prevent  this  outcome.  Overthe course  of  a  given  negative  trading  cycle—particularly  for  those  whohave self-imposed limits—there will often be temptation to point toward spe-cific sets of unique external factors (a market crash, a divorce, negative vibesfrom your astrologer) and to adjust your stop-out level downward. 
Please resist this temptation. I find that 90% or more of the time theexternal factors you believe are at the root of your problems may very wellrepresent a partial cause, but rarely do they tell the complete story. Thingsseldom  turn  themselves  around  without  fairly  dramatic  actions  in  thesecircumstances, and by far your best bet is to simply step aside and shiftthose energies that you were applying to the markets toward an objectiveassessment of what went wrong.
One of the