Overall exposure refers to the part of total capital that a trader is willing to risk across all potential trading opportunities. Risking 100 percent of the balance in the account could be dangerous if every single trade fails. At the same time, risking only 1 percent of capital mitigates the risk of losing the entire capital, but the resulting profits are extremely minimal.
The fraction of capital you are willing to trade depends upon the returns expected from the portfolio. Simply put, the higher the expected returns the greater the recommended level of capital. The optimal exposure of the capital you are willing to risk would maximize the overall expected return on a trades you are willing to take. To make it easier for our analysis, let’s use data on the completed trade returns as a proxy for expected returns.
One more relevant factor is the correlation between security returns. Two securities are considered to be positively correlated if a change in one security is accompanied by a similar change in the other. Similarly, two securities are considered as negatively correlated if a change in one security is accompanied by an opposite change in the other.
The strength of the correlation depends on the magnitude of the relative changes in both the securities. In general, the greater the positive correlation across securities in a portfolio, the lower the theoretically safe overall exposure level. This safeguards against multiple losses on positively correlated securities. By the same logic, the greater the negative correlation between securities in a portfolio, the higher the recommended overall optimal exposure.
The overall exposure of the capital could be a fixed fraction of available funds. Alternatively, the exposure fraction may go up and down along with the changes in the trading account balance. For example, a trader who is aggressive might want to increase overall exposure when he sees a decrease in his account balance. While a defensive trader might be more conservative and chose to increase the overall exposure only after witnessing an increase in his account balance.
As there is an old saying which suggests us not to keep all the eggs in one basket, it is dangerous to expose a huge chunk of your capital when you trade. Especially when you are skeptical about it. It is recommended to wisely allocate the risk capital on the order of your most favorable trades.
It can be really difficult to control the overall exposure when you margin to trade as the rewards are really tempting. But those are the time you should be extra careful in exposing your capital wisely with emotional and financial discipline.
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