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Herman,
To understand what various authors mean by position sizing you need
to distinguish between the amount of money invested in a trade and
the amount of money "at risk" in that trade. The amount of money at
risk may only be 10%, 5% or even just 2% of the money used to buy a
stock.
Below is a copy of a post I made about this on another discussion
board.
b
-------copy-------
Subject: Managing Risk & Increasing Profit (was How to Test VV
strategies)
http://groups.yahoo.com/group/vectorvestonlineusersgroup/message/2932
8
--- "Dennis Fluegel" <dfluegel@xxxx> wrote:
> "Absoluely brilliant!. You've nailed it!
> ... your post ... should be required reading."
Thanks for the kind words. That post addressed risk management for
just one of several investing approaches. Those principles would not
be appropriate to all types of investing. Thus the disclaimer
stating "You are also responsible to ensure that your education is
sufficient for the type trading you plan to do."
You mention that many of the books on risk management seem to
contradict each other. In addition to differences of personal risk
tolerances of the authors, the apparent contradictions may arise
because the books focus on very different trading approaches.
Risk management formulas for trading in the "futures" market will be
very different than those that focus on trading Options, which will
differ from those trading stocks. Even among those trading stocks,
there are key differences between trading stocks as "individual"
entities and trading stocks as groups or "baskets". My personal
trading approach is along the lines of the "basket" approach, and
thus my prior post related to managing risk (and increasing profit)
for stock baskets using market trend signals to time entries and
exits.
Books on risk for futures trading have to take into account the
massive leverage (much more leverage than buying stocks on margin).
So the formulas they suggest will have very low thresholds.
Many books on risk management for stocks do not address risk
management approaches for baskets of stocks. Instead they focus on
managing risk (and thus maximizing profit) when stocks are not
bought and sold as a group, but individually with different entry
dates (usually based on a timing signal based solely on a stock's
chart). In such approaches there is a lot to be said for a "position
sizing" approach to risk management.
Position Sizing is a fascinating study in how mathematics can
influence strategy, execution, and profits. The results can be
surprising. For reasons to be explained, I personally only use it
occasionally, but I find it fascinating.
Generally position sizing assumes one can find a "logical" place to
set a stop loss exit. Finding a logical stop loss point can be done
if entries are timed, not by the market trend, but by an individual
stock's price chart. The timing decision to enter is based on
recognition of a chart pattern. (A great book on how to recognize
and trade chart patterns - and which not to play! - is Thomas
Bulkowski's Encyclopedia or Chart Patterns). Typically a "logical"
place to set a stop loss would be the price point when one would
know that the chart pattern has broken down. Without a pattern in
place, a chart reading trader has no idea where the stock price may
go and thus no reason to expect it is more likely to go up than
down -- certainly if one has no clue about a stock's direction it is
time to exit that trade! One can use trend lines, "neck lines", and
support and resistance lines to set stop exits. Generally one sets
the stop exit order a bit below the price signal (to avoid being
food for market makers who may try to trigger obvious stop levels).
Once one has decided upon a Stop Price, then the math is fairly
simple. Take the distance in dollars from one's Entry Price to the
Stop Price (add a bit more for "slippage" and commissions). That
amount is the risk per share (RPS). One also selects a maximum
single loss percentage of one's total trading capital. Common
percentages suggested are 1%, 1.5% and 2%. Some authors say 2.5% or
3% single stock loss risks are for "gunslingers". These numbers are
combined to tell a person what "position size" to use for an
individual stock entry (ie, how many shares to buy).
So if one plans to buy a $100 stock and sets a "logical" stop loss
exit at $98, the distance is $2 a share. Add perhaps 50 cents for
slippage and commissions and the RPS is $2.50. If one has a trading
account of $20,000, then a 2% maximum single loss (MSL) would be
$400. What is the position size formula? MSL/RPS = $400/$2.50 = 160
shares of the $100 stock. That is a $16,000 commitment to a single
stock!!! So, a 2% maximum single risk is not necessarily a limiting
factor.
By the way, those who trade this way usually have couple additional
rules. One additional rule will limit the a maximum percentage to be
put into a single stock (perhaps 25% or 20% or less), so they would
not put over half their funds into a single stock. In addition some
will have a 6% aggregate exposure rule. So they have 3 trades in
play each with a 2% outstanding RSP, they will not enter any new
trades (even if they have cash sitting in their account). However,
if a stock goes up as hoped, one can replace the stop loss exit
order with a trailing stop order set above the entry price -- and
thus, according to this line of reasoning, that trade's RSP is now 0
(zero). That reduces the aggregate outstanding risk to less than 6%,
so new trades can be entered until the aggregate risk gets back to
6%. That gives the basic idea of one particular approach to risk
management when stocks are traded individually.
What if that $100 stock has moved from the time you decide to buy it
to 102.50 by the type you have typed in your buy order? Well, one
should reduce the number of shares to compensate for the fact the
RPS is now 102.50 - 98.00 = 4.50 plus the 50 cent slippage = $5.00.
Thus the order should be for $400/$5 or 80 shares. What if the
stocks dips to 98.50? Well, that would be a RPS of 1.00 (remember
the 50 cents slippage) so the math is 400/1 = 400 shares or $39,400.
Of course the secondary rule of only 25% in a single stock would cap
this at a lower level.
What if the stock dips to 97.50? Walk away. The stock has broken its
chart pattern and is "misbehaving".
If one can set a logical "price target" based on the chart pattern
(Bulkowski's book has some insights on this), there is some
additional math that can be used to rank which trades are the most
profitable to take. In general terms, it is Possible Realistic
Gain / RPS. One could call this a "Risk Return Ratio" (RRR) but I
like to reorder the words to be "Reward/Risk Ratio" - just the way
my mind likes to name things - the concept has not changed.
If you only had enough aggregate risk space left to take 1 new
trade, would you take trade A with a potential gain of $8 or trade B
with a potential of $12? It would all depend on what the RSP is for
each trade. If the stop exit is very close to the entry price for
trade A but far away for trade B, then trade A would have the higher
RRR. Taking trade A would give a smaller percent gain on the trade
but the dollar gain would be higher (because the closer stop would
allow a larger position size). Thus trade A would bring in more
profit than trade B. Math is amazing!
The math and strategizing is neat stuff. But it is almost totally
irrelevant to my trading - because my general approach is to trade
stocks as basket based on market timing rather than individually.
Occasionally (and just for "fun") I will do some chart reading and
calculate some RPS and RRR numbers. Very occasionally I might place
a trade based on this.
As for my preferred approach, position sizing does not appear to be
applicable due to the lag of my market timing signal. As a result
the stocks that my strategies pick are generally so far away from
any "logical" stop when the market timing signal goes off, that I
(currently) do not see an advantage to using RSP to position size
and RRR to rank. However, I am keeping an open mind about this.
Because if one could find a way set individual exit stops (not
percentage based, but dollar based or perhaps ATR based), then one
might be able to increase profits without increasing risk.
b
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