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>To expand on what I was trying to communicate earlier about finding an
>optimal amount to invest in stocks, my plan is to try to combinte the
>concept of maximum adverse excursion with fixed fractional investing to
come
>up with a money management formula for stocks.
While these are good concepts, as someone who trades stocks I tend to view
them as good background info to know but to use my gut comfort level with
P&L variations to define my appetite for risk.
It doesn't have to be this complicated or painstakingly derived.
Each person ends up coming to nirvana using whatever works for them in
controlling risk - like in managing a business, there is no one right or
wrong way - there are multiple ways, and each has its own cost-benefit
tradeoffs and its assumptions.
>Since stocks can have catastrophic losses I would never want to "put all of
my
eggs in one basket"
>The question in my mind now becomes, is 20% less than or equal to the
>optimal amount that should be traded based on optimal f or whatever to
>maximize my return.
In reality, the $20,000 is exposing 20% of your account equity on one trade.
If the stock moves in sync with other positions active in your portfolio,
then you're concentrating more than 20% on a single trade - whatever its
reason for initiation may be. If you buy only CANSLIM breakouts, for
example, you're 100% trading one chart pattern even though you may break it
down into 4-10 stocks.
Stocks have gap risk as well. Ask recent and past holders of CA for
example - it is notorious for gapping down 50% in the earnings season.
So theoretically you may want to stop yourself out at 2% but the gap just
sent your account down by 10% on this position and whatever else that went
down in sympathy with it.
Hence, options make sense as a defensive instrument. Gives you the liberty
of concentrating 20% of the portfolio in one trade, the 2% you're willing to
lose on the direction gone wrong buys you the protection for an upfront
payment simultaneous to your buying the stock position, and you're left with
all your capital should a gap occur adverse to the intended directional
move.
Psychologically it is easier to come out of a loser trade when you know you
are protected no matter what - and pragmatically it is easier to recover
from the down payment of premium (the 2%) than to recover from a 50% gap
down.
I haven't read any of Ralph Vince's books - but I wonder if he addresses
these issues like opening gaps, limit moves against the position etc. No
amount of quantification does away with the psychological damage they
inflict.
Above, of course, assumes you take positions home overnight.
Gitanshu
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