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For those interested, Van K. Tharp writes in "Trade Your Way to
Financial Freedom" an excellent explaination of position sizing and
risk management. Specifically you should refer to Table 12-4 in
Chapter 12. A moving average crossover system is discussed where risk
is varied from 0.1% to 35% of the total portfolio value.
At 2.5% risk level, the maximum drawdown is 29%
At 5% risk, the max DD increases to 46%
At 35% risk, max DD goes to 104% - ie your portfolio value goes to zero.
Put in simple terms, in a typical trading system, if you risk 1/3 of
your portfolio on each trade, in a relatively short time you can
expect to trade the account to zero. What actually happens is that
after several consecutive large losses the individual simply stops
trading - hopefully above zero equity.
Even at the 2.5% risk level, few traders would be willing to keep
trading a system where they would lose nearly 1/3 of their equity.
THAT is why you see the 1-3% number come up.
As an individual investor, I use a risk of about 0.8% - that produces
drawdowns around 10% - a number I can live with.
Ed Hoopes
--- In equismetastock@xxxxxxxxxxxxxxx, "Jose Silva" <josesilva22@xxx>
wrote:
>
> > Many people use 1~3% risks for their investment, but does anyone
> > know why?
>
> No one knows what lurks in the minds of traders, otherwise we could
> preempt the public and become quite wealthy practically overnight. ;)
>
> I suspect that the main reasons for a fixed (1%~3%) trade capital
> allocation are based on a misunderstanding of risk, or an inability to
> measure and act on risk properly.
>
> The main reason for capital allocation (money management), is to
> control risk to some extent.
>
> Allocation of capital (i.e., exposure to risk), should be done on an
> individual security basis. That is, look at individual trade history
> for each security, and allocate x% of capital to it according to
> historical risk.
>
> For example, a risky/volatile stock may require caution and a smaller
> capital outlay, whereas a more stable/trending security with less
> historical risk, can cope with a larger trade size.
>
> In other words, don't allocate capital % on hearsay or fixed
> percentages. Be smarter, and allocate capital according to individual
> risk exposure.
>
> More on this in the current issue of MSTT.
> http://www.metastocktips.co.nz
>
>
> jose '-)
> http://www.metastocktools.com
>
>
>
>
> --- In equismetastock@xxxxxxxxxxxxxxx, chichungchoi <no_reply@>
> wrote:
> >
> > Many people use 1~3% risks for their investment, but does anyone
> > know why? Does it have any approach to determine the risk level
> > based on the performance of any strategy?
> > Thank you in advance
> > Eric
>
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