Portfolio heat

An aggregate risk figure, and an informal one. For each open position the distance from its entry to its protective level is multiplied by the money value of one unit of that distance, the results are added, and the total is expressed as a percentage of equity. No regulator, exchange or data vendor defines it: the measure comes from trend following literature, and it exists because a set of individually modest positions can add up to an immodest exposure that no single position's risk figure reveals.

Adding the positions up is where the measure gets interesting, because they do not contribute independently. Positions in instruments that move together tend to lose together, so a straight sum understates what one adverse day can produce, and the practice varies: some practitioners group correlated positions and count the group once at the size of its largest member, others apply a multiplier to the group, and others ignore the issue. Each convention produces a different heat figure for the same book, which is worth knowing before two figures are compared.

Two limits are structural. The figure assumes each protective level fills at the level named, which a gapping market does not honour, so heat describes a floor on a bad day rather than a cap on one. And the ceilings usually quoted alongside it, a low single digit percentage per position and something in the low double digits for the whole book, are conventions circulated in trading literature rather than findings with an evidence base, which is precisely why published versions of the rule differ from each other by a wide margin.