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Portfolio Heat & Correlation Cap

Updated Jun 23, 2026 at 8:47pm

Research Draft Medium 761 words

Portfolio heat is the total fraction of account equity that would be lost if every open position were simultaneously stopped out at once. Where per-trade risk asks "how much do I lose on this one trade if I'm wrong," portfolio heat asks "how much do I lose if I'm wrong on everything at the same time." A trader can size each individual swing trade conservatively and still blow up, because the aggregate exposure — especially across correlated names — is what actually gets tested in a sharp market reversal. Heat-and-correlation discipline closes that gap by capping the sum of open risk, not just the size of any single bet.

Portfolio heat

Portfolio heat is the simple sum of the per-trade risks across all open positions. If each trade risks a defined dollar amount (entry-to-stop distance × shares), then heat = (sum of those dollar risks) ÷ equity, expressed as a percentage. Four positions each risking 1.5% of equity carry 6% heat: if all four stops fire in one bad session, the account drops roughly 6%.

The concept and its caps trace to Van Tharp's position-sizing work. His guidance is to think in terms of total portfolio risk and to keep no more than roughly 6–10% of capital at risk across all positions combined at any one time. Dedicated portfolio-heat literature is tighter, treating a maximum total heat of about 5–6% as the threshold beyond which a single correlated event can do serious, hard-to-recover damage; institutional risk desks often run lower still. The exact number is a system choice, but the principle is fixed: heat is bounded, and new positions are sized so the cap is never breached.

Correlation

Heat measured as a naive sum understates real risk when positions move together. Two highly correlated names — same sector, same factor exposure, same macro driver — are not two independent bets; they tend to hit their stops on the same catalyst. Three tech names each risking 1.5% are not 4.5% of diversified risk; in a tech-wide selloff they behave closer to a single concentrated 4.5% position. Correlated positions should therefore be counted together against the heat budget, and concentration within any one sector or theme should be capped (a common rule of thumb in heat literature is limiting any single sector to roughly 20–30% of total heat). Adding a fourth correlated name does not diversify — it deepens an already-concentrated exposure.

Worked example

A swing book holds four positions, each sized to risk 1.5% of equity → 6% nominal heat, at the upper bound of a typical cap. If three of those four are semiconductors, the "6%" is misleading: on a sector-wide gap-down those three correlated names (4.5% of nominal risk) can all stop out together, so the effective worst-case loss clusters far above what the per-position math implies. Under a sector-concentration cap, the trader would have stopped at one or two semis and required the remaining slots to come from uncorrelated sectors — keeping the 6% genuinely spread rather than concentrated.

How it's used in practice

Heat is a hard gate applied before a new position is opened. The workflow: compute current open heat → compute the candidate trade's risk → check that the post-add total stays under the heat cap → and separately check that adding the name does not push any sector or correlation cluster over its concentration cap. If either check fails, the trade is rejected, downsized, or deferred until an existing position is closed and frees up heat budget. This makes risk an account-level constraint rather than a per-trade afterthought.

Strengths & limitations

The strength is catastrophe avoidance: bounding aggregate heat keeps a single bad day from being an account-ending day, which preserves both capital and the psychological capacity to keep trading. The headline limitation — and the #1 misuse — is respecting per-trade sizing perfectly while ignoring aggregate and correlated heat: ten "small" 1% positions in the same sector is a single ~10% concentrated bet wearing a diversified costume. Secondary limitations: correlation is estimated, unstable, and tends toward 1.0 exactly when it matters (in a panic, everything correlates); and a fixed heat cap is a blunt instrument that doesn't distinguish high- from low-conviction setups.

System relevance

In the Augustus pipeline, portfolio heat and correlation caps act as a pre-trade gate: before a candidate position is admitted, the system checks the new trade's risk against the remaining heat budget and against per-sector / correlation-cluster concentration limits, rejecting or downsizing entries that would breach either cap.

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