12/31/2010

How to approach per trade risk

One of the key determinant of your returns is how much you risk per trade. Given same number entry and same exit your gains is a function of how much you risked on a trade. 


Let us say you hold 25 open positions with 4% allocated to each and buy a stock at 10 and sell it at 20, you will make overall 4% profit on your account. As against that if you hold only 4 trades at a time with 25% risk each then on same trade with same entries and exits your overall account will be up 25%.

Traders use various ways to decide on how much to risk per trade. Many times they start using a method to size a trade and stick with it and without paying much attention to its consequences continue to use it. 


If you study various ways to size a position and how it will affect your overall profit then you will be in a better position to decide what is best way to size a trade and what are the advantages and disadvantages of each approach. 


Like everything else in trading the sizing of trade has been studied extensively and you will find that there is lot of information about it in public domain. If you make a one time effort of few days to few weeks researching this are and understanding it thoroughly, you can significantly improve your profits with your existing methods. By just doing proper risk management you can even double your profit if you have been risking very small amounts on trades.

Let us look at some of the most commonly used approaches in sizing the trades. 


The most commonly used approach by many traders is fixed share lots. Lot of time traders buy 1000 or 500 or 300 lot on each trade. This is very common way to trade amongst day traders and swing traders. 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. They just set lot size at 500 or 1000 or any other number and keep buying in those lots. But it is not necessarily the best way to approach risk. Dollars is more important not lot size. 


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. The primary reason for this approach is again convenience. This approach also has a problem of allocating too large a amount on lower priced stocks. Besides that it does not account for stop loss properly. 

Some do not put more than 4  % 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 of 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. 

How you size a trade also depends on whether you are a trader or investor. As a trader you are  looking for aggressive returns. Your position size as a trader is also function of your trade frequency. If you are trading infrequently like many investors do then they must risk enough on trade to compensate for low frequency. 


A high frequency trader can risk lower and still make higher return if that person rotates capital multiple times. Other consideration for a trader is that you can actively manage risk as against someone who invests. I monitor my positions all the time and can quickly close a position if it is not working or starts going down. The active management of risk gives much more control over risk and as a result I can risk much bigger amounts that someone who can not control risk.


Ultimately several factors go in to determining  your sizing strategy. If your overall goal is triple digit plus profits then your risk strategy will be different from someone whose goal is 20% return for the year. If you are aiming for higher returns you have to risk higher. If your win ratio is 50% you look at risk differently from someone with 70% ratio. As against that a trend follower might have only 25% win loss ratio and need to factor that in. 


Your frequency of trades matter. If you are going to make only 10 trades in a year then your risk approach is different. As against that if you are making 200 trades in a year or 40 to 50a day as some day traders do  your risk approach will be different. Your returns per trade also determine your risk approach. 

If you have been trading for some years or have sufficient number of trades then you can analyse them and have data to work with and then have a much better way to determine your trade sizing. 

I use a % risk model. I risk anywhere from .25 to 10% on a trade. But most trades are around 1% risk. What does 1% risk means? It means how much will be the loss if my stop is hit. So 1% risk means if my stop is hit I will have 1% loss on total capital. It does not mean that I have 100 positions open with 1% risk. 

Actual size of your trade might be much larger in percentage of account invested. You might have 50% of your account invested in one trade and your risk can still be 1%. Because risk=entry price-stop. 

For example if you see one of the swing trade I did in 2010 on GMCR. I got in to the trade at 94.45 and my stop was 94 and my risk was .5% but the total money invested was 105% of the account. Similarly if you see my RIG trade you will see that I entered at 64.45 and stop was 64. The risk was .25% but the amount invested was 36% of the total account. 

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= XYZ


Entry price= 25


Stop (minl3)= $24.50


Risk per share= 25-24.50=.50


$1000(1% risk)/$.50=2000 shares to buy


2000* 25 (entry price)= $50000 worth of stock to buy.


So for a $100000 USD account, I will buy 2000 shares of this stock or invest $50000 in this one XYZ stock.


If I get stopped out after buying this stock position, I will lose 1%, or $1000 which is (entry price-stop)

There is a handy calculator to do this here


http://stockbee.biz/position-size-calculator/



In this kind of an approach you can get fully invested in 3 or 4 positions by just risking 1% per trade. If you have 4 positions open with 1% risk each then you have 4% at risk. 


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. If you see some of the trades I did last year, there were these kind of situations where I had anywhere from 50% plus to 105% plus on single trade but my risk was below 1%.

The basic assumption in this calculation is that you will be able to get out at stop price and stock will not gap down significantly below your stop. That is where your skill in selecting stocks to trade and selecting entry point comes in. 


If you see my overall trades over many many trades there are negligible number of trades with 10% plus loss. There were only 4 trades with above 10% loss and out of that only one trade where loss was more than 10%. The worst loss on a trade was 12.28% on a single trade on invested capital. But as a % of account that loss was only .92% loss. 


Overall out of all trades only .04% trade has a loss of 1% plus on overall equity. The worst loss was 1.77% but on that particular trade the risk was 2% so it was still below pre determined risk.

The kind of approach I use 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 a single trade size. Like saying 1% of account at risk but individual position should not be more than 30% of account. Or by specifying only 6% of account should be at risk at any time.

You can use Telechart PCF to do above calculation instead of using my calculator. That is quicker way to find how many shares to buy once a Trade Alert is issued. For that follow following steps.

Let us assume you have 100000 in account.

Then a PCF for deciding number of shares to buy for 1% risk will be  

100000/100/(c-l)

This assumes your stop is low of the day.

Now you need to change your capital amount everyday for this pcf to work. Let us say you closed a trade and your new capital base in 130000 then the pcf needs to change to

130000/100/(c-l)

A PCF for deciding number of shares to buy for .5% risk will be  

100000/200/(c-l)

A PCF for deciding number of shares to buy for .25% risk will be  

100000/400/(c-l)

The risk approach above should be married with other things like market timing, situational awareness, stock selection, and your cumulative returns till date. 


As you will see I take smaller risk positions if market direction is uncertain. Similarly I risk less when market is in extreme zone and has higher probability of reversal. Same way not every idea is worth risking 2% or 5%. So very few trades have that kind of risk. 


There is also phasing of risk. Once you are up 50% plus in first few months your risk strategy can either protect that profit or use that profit buffer to go for a kill. These are all variables which are under your own control and you have to use them based on situation. 

Overall as a general observation, concentrated position is key to high returns. Diversified positions reduce risk and returns. Concentration builds wealth, diversification protects wealth. 


Your risk approach should be based on what stage you are in. Are you in wealth building stage or in wealth protection stage. That question depends on each individuals specific life situation. 


Every trader has different risk tolerance and based on their situation they should find their own risk management strategy. 







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2 comments:

rmike said...

Dear Pradeep,

Thanks for very lucidly highlighting the importance of position sizing in your latest post. I have been using the method suggested by you for quite a while now and can attest to enhanced returns. I would appreciate if you could also share your thoughts upon your take on the method of effective stop loss (since the risk control and position sizing is virtually dependent upon the magnitude of the difference between entry and stop loss) and profit projection determination.

Wishing you all the very best for the year 2011.

Thanks and regards, rmike

Pradeep Bonde said...

Thanks.

Will talk of stops in later post.

Happy New Year