How much should you risk on a trade? | stockbee

10/11/2010

How much should you risk on a trade?

Traders use various ways to decide on how much to risk per trade.



Fixed share lots. Lot of time traders buy 1000 lot. Dollars is more important not lot size. Buying 1000 shares of 5 dollar stock would have 5000 invested. Buying 1000 shares of 50 dollar stock would be 50000 invested. If your account is 100000 then one trade will be 5% while other would be 50% of your account. If both stocks doubled. In first case you will have only 5% return while in the second case 50% return. Due to convenience lot of time traders follow this approach. But it is not necessarily the best way to approach risk.

Fixed amount. Say 10000 in each position. Many traders divide their total capital in some foxed lot of say 10000 and then every time buy only 10000 worth of shares. So in 100k account they will carry 10 positions. 

Some do not put more than 4 or % in a single position. In this case they carry 25 positions. This kind of approach reduces individual position risk. If one of the stock gaps down 50% , you would only have overall only 2% loss. This is the kind f approach used by mutual funds. Many mutual funds even go further and hold 100 or more position. One of the problem with such approach is while it reduces risk , it also reduces returns. greater the diversification lesser is your return. 

I use a % risk model. I risk anywhere from .25 to 10% on a trade. But most trades are around 1% risk. To manage risk, you should not risk more than 1% of your total equity on a single trade. This means that if your account size is $100,000 USD, you would risk $1000 on a single trade. What that means is if your stop is hit , your would only lose 1000 dollars. Actual size of your trade might be much larger in percentage of account invested. 

In my approach I first determine % of risk to take on a trade. So let us say if the account is 100k and if I decide to risk 1% then the amount to risk is 1000USD.  To calculate the number of shares to buy, find the difference between entry price and stop price and divide the result into 1000.


Number of shares to buy= 1000/(entry price-stop price)




Total account capital=$100000


1%=$1000


Stock to enter= DDS


Entry price= $25.27


Stop (minl3)= $24.31


Risk per share= 25.27-24.31=.96


$1000(1% risk)/$.96=1041 shares to buy


1041* 25.27 (entry price)= $26322 worth of stock to buy.


So for a $100000 USD account, you will buy 1041 shares of this stock or invest $26322 in this one DDS stock.


If you get stopped out after buying this stock position, you will lose 1%, or $1000.


In this kind of an approach you can get fully invested in 3-4 positions. If you find a situation where the distance between stop and entry price is small then you can have a big position in a stock with just 1% risk. For example look at same example of DDS above with entry at say 24.75 and stop remains at 24.31. 

Number of shares to buy= 1000/(entry price-stop price)


Total account capital=$100000


1%=$1000


Stock to enter= DDS


Entry price= $24.75


Stop (minl3)= $24.31


Risk per share= 25.27-24.31=.44


$1000(1% risk)/$.44=2272 shares to buy


2272* 24.75 (entry price)= $56250 worth of stock to buy.


So for a $100000 USD account, you will buy 2272 shares of this stock or invest $56250 in this one DDS stock.


If you get stopped out after buying this stock position, you will lose 1%, or $1000.

This kind of approach can help you quickly ramp up your gains under right conditions. Your risk is of a stock gapping down more below your stop and making 1% risk much bigger risk. One of the ways some people reduce that kind of risk is by specifying a limit on single trade size. Like saying 1% of account at risk but individual position should not be more than 30% of account. 

Overall as a general observation, concentrated position is key to monster returns. Diversified positions reduce risk and returns. Every trader has different risk tolerance and based on their situation they should find their own risk management strategy. 

2 comments:

Mannu said...

The 1% risk model works in theory practically there is additional cost of brokerage/slippage/taxes which adds up in that so with 1% risk if a trade hit sl and if brokerage and taxes which come around to .50% in India (thou vary frm diff brokers) u end up loss more than 1% on sl

if one trades with 1:1R this senerio does not produce convincing results.

in pos. sizing also if 1:1R we trade as day or swing trader and u buy a stock worth 3000Rs with ur stop at 2960 for a target of 3040 which would mean 1:1R position of shares 1000/40 = 25 will cost

25x3000 = 75000 after calculating the sl and tgts and commission one must have trades with Higher R multiples else position size or 1% will nt give gains

Pradeep Bonde said...

That is why we look for 4 R kind of situation.