You might have perfect position sizing for each individual trade, but if you ignore your total portfolio exposure, you are still vulnerable to catastrophic losses. Portfolio heat measures your combined risk across all open positions. Managing it is essential for surviving market shocks and black swan events.
What is Portfolio Heat?
Portfolio heat is the total percentage of your account at risk across all open positions. If all your stop losses were hit simultaneously, portfolio heat tells you how much you would lose.
Simple definition: Portfolio Heat = Sum of risk from all open positions. If you have 5 trades each risking 2%, your portfolio heat is 10%.
Why Individual Position Sizing is Not Enough
Many traders focus only on per-trade risk without considering the bigger picture. Here is the problem:
The Scenario
- You risk 2% per trade (perfectly reasonable)
- You open 10 positions during a bullish period
- Total portfolio heat: 20%
- Market crashes overnight
- All 10 positions hit their stops
- Result: 20% drawdown in one day
This scenario is not hypothetical. In market crashes, correlations spike to 1.0 and everything moves together. Your "diversified" positions become one giant position.
Setting Your Maximum Portfolio Heat
Maximum portfolio heat depends on your risk tolerance and trading style:
- Conservative: 5-10% maximum heat
- Moderate: 10-15% maximum heat
- Aggressive: 15-20% maximum heat
- Very Aggressive: 20-30% maximum heat (not recommended)
Recommendation: Start with 10% maximum portfolio heat. This means you could have 5 positions at 2% risk each, or 10 positions at 1% risk each.
Calculating Your Current Portfolio Heat
For each open position, calculate the risk at your stop loss, then sum them:
Portfolio Heat Calculation
Account: $50,000
- Position 1: 200 shares, risk $3/share = $600 (1.2%)
- Position 2: 100 shares, risk $5/share = $500 (1.0%)
- Position 3: 150 shares, risk $4/share = $600 (1.2%)
- Position 4: 300 shares, risk $2/share = $600 (1.2%)
Total Portfolio Heat: $2,300 or 4.6%
If max heat is 10%, you have room for another 5.4% in new positions.
Adjusting Heat for Correlation
Not all positions are equal. Correlated positions effectively act as one larger position:
Types of Correlation
- Same sector: Five tech stocks will move together
- Same direction: All long or all short positions
- Same market: Everything moves with SPY in a crash
- Economic exposure: Oil companies and transportation
Correlation-Adjusted Heat
You have 5% heat in tech stocks (AAPL, MSFT, GOOGL). Because they are highly correlated, treat this as closer to a single 5% position rather than three diversified positions.
Adding another tech stock adds to the concentrated 5%, not to a diversified portfolio.
Heat Management Strategies
1. Sector Limits
Set maximum heat per sector:
- Maximum 5% heat in any single sector
- Maximum 3% in highly volatile sectors
- Force diversification across sectors
2. Direction Limits
Balance long and short exposure when possible:
- Maximum 15% net long heat
- Maximum 10% net short heat
- Consider market-neutral strategies
3. Time-Based Limits
Consider when positions will resolve:
- Positions expiring same week count as more concentrated
- Spread expirations to reduce simultaneous risk
Dynamic Heat Management
Your heat limit should not be static. Adjust based on conditions:
Reduce Heat When
- VIX is elevated (above 20-25)
- Major economic events approaching
- You are in a losing streak
- Market structure is uncertain
- Earnings season for your holdings
Increase Heat When
- Volatility is low and stable
- You have high-conviction setups
- You are in a winning streak (with caution)
- Market trend is clear
Reducing Portfolio Heat
When your heat exceeds your limit, you have options:
- Close positions: Exit your weakest or most correlated trades
- Reduce position sizes: Scale out of existing positions
- Tighten stops: Move stops closer to reduce risk (be careful not to get stopped out too easily)
- Add hedges: Put protection or index shorts to offset long exposure
- Wait: Do not open new positions until heat decreases
Heat Management for Options Traders
Options traders need to consider different risk calculations:
- Long options: Heat = premium paid
- Credit spreads: Heat = max loss (spread width - credit)
- Iron condors: Heat = max loss on one side
- Naked options: Heat is theoretically unlimited - use margin requirements as proxy
Options Heat Example
Account: $50,000, Max Heat: 10% = $5,000
- 3 put credit spreads, max loss $400 each = $1,200
- 2 call credit spreads, max loss $500 each = $1,000
- 1 iron condor, max loss $800 = $800
Total Heat: $3,000 (6%)
Room for $2,000 more in new positions.
Track Your Portfolio Heat Automatically
Pro Trader Dashboard monitors your total exposure across all positions and alerts you when you exceed your risk limits. Never accidentally over-expose your portfolio again.
Common Portfolio Heat Mistakes
- Adding during drawdowns: Do not increase heat when already losing
- Ignoring correlation: Diversified names are not diversified if they are correlated
- Forgetting about gaps: Overnight gaps can exceed your stop losses
- Weekend risk: Holding over weekends means extra uncontrollable risk
- Not tracking heat in real-time: Your heat changes as positions move
Summary
Portfolio heat management is the often-overlooked companion to position sizing. You need both. Set a maximum portfolio heat based on your risk tolerance (10% is a good starting point), account for correlations between positions, and adjust dynamically based on market conditions. This discipline protects you from the catastrophic drawdowns that end trading careers.
Want to learn more? Explore correlation risk in trading or understand tail risk management for extreme market events.