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b,
Thanks for the post. I have to chime in here because, although I agree with
your overall treatise on money management, I believe you can achieve your desire
to increase profits without sacrificing risk simply by setting your stops based
on volatility (ATR). When you do this, you equalize all the stocks in your
portfolio, at least in the beginning, so that your profit and loss potential are
approximately equal across all stocks while your risk stays fixed at x% per
stock (set x to whatever you like or can tolerate). So, if Stock A has a high
volatility and Stock B a low one, you simply buy less of Stock A and more of
Stock B to compensate for the difference in volatility. Here's an example:
assuming your equity were $100 K for ease of calculations and taking your $100
stock (call it Stock A) as one you want to buy, if its ATR is, say, $3, your
risk tolerance is 1% of equity, and your stop based on your system is, say,
2*ATR below the buyprice, then you would buy 1000/2*3 or 167 shares ($16,666
commitment). Now, suppose you also want to buy Stock B, whose price is $50 and
ATR is 1. You would buy 1000/2*1 or 500 shares, commiting $25,000 of equity.
Notice that you commit more equity to the lower volatility stock (its ATR is 2%
of the price vs. the higher volatility stock whose ATR is 3% of the price). Now
you have 2 stocks in your portfolio that will have approximately the same profit
and loss potential based on price movement because you have equalized your
trades based on their volatility. This, to me, makes a lot more sense than
basing your max stoploss on a fixed dollar amount based on a trend line or
something like that.
Now, I have a question for you. What do you mean when you say you buy a
basket of stocks rather than individual stocks? Do you mean indices or industry
groups like biotech, semiconductors, etc.? If so, then you can treat those
indices just like stocks and use position sizing as above, based on ATR. If you
mean mutual funds, you cannot calculate ATR since you need OHLC data. But you
can calculate standard deviation of NAV over the last x days to give you an
estimate of volatility, which could serve very well as a substitute for ATR. If
by basket you mean something else, please help me understand what you mean. I
ask because I cannot envision why you cannot use position sizing for any type of
trading system.
Thanks for the interesting discussion.
Al Venosa
<BLOCKQUOTE
>
----- Original Message -----
<DIV
>From:
b519b
To: <A title=amibroker@xxxxxxxxxxxxxxx
href="">amibroker@xxxxxxxxxxxxxxx
Sent: Tuesday, September 23, 2003 12:03
PM
Subject: [amibroker] Position Sizing,
math, and profits
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)<A
href="">http://groups.yahoo.com/group/vectorvestonlineusersgroup/message/29328---
"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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