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First, the subject of position sizing and risk management is
complicated. I'm not sure that it is possible to adequately cover the
topic in this type of forum. The following should get things started.
I will use an example:
Say you have a portfolio of $100,000.
Say you have a trading system that produces 60% wins 40% losses
Say the average profit is double the size of the average loss
Say you want to have a maximum drawdown of 20% each year
Question:
Every time you get a buy signal, how much of the 100K do you invest?
If the trade goes your way, when do you sell? (Your expectancy)
If the trade goes against you, when do you sell? (your risk)
Academic studies have shown that portfolio returns can be greatly
enhanced by correctly answering the above questions. Some say that
the MAJORITY of the returns you get come from correct position sizing
and risk management.
One of the reasons that this is so important is the assymmetry between
gains and losses. If you lose 10% of your portfolio value from a
string of losses, you have to gain 11% to break even. If you lose
50%, you need to DOUBLE your money (100%) to get back to break even.
The following comes from Tharps book (cited in an earlier post)
Definition: RISK is max allowed loss on each position. 1% risk is max
loss of $1000 per trade.
A 1% risk yields 7.2% annual return and 13.2% drawdown. So if you
used a POSITION SIZE of $5000, you could lose 20% ($1000) on each
trade and attain a profit of $2000 (gain is double loss). Also with a
$5000 position size you could put on 20 positions.
You may say a 7.2% return is not that good. In Tharps table the
maximum return was 93.5% per year when you set your position size at
25% but your maximum drawdown would be 83% ! ! So during the year on
your way to nearly doubling your money your account balance could
dwindle to from $100,000 down to $17,000. I would say that virtually
no one would trade through a DD like that.
So there is some balance point between trade system selection,
position size, risk control, drawdown etc etc where you can trade to
get maximum profit with minimum drawdown and minimum sleepless nights.
Such is the importance of POSITION SIZING and RISK management.
Ed Hoopes
--- In equismetastock@xxxxxxxxxxxxxxx, "Lionel Issen" <lissen@xxx> wrote:
>
> Using higher risk levels, couldn't these drawdowns be limited using
stops?
>
>
>
> Lionel
>
>
>
> _____
>
> From: equismetastock@xxxxxxxxxxxxxxx
[mailto:equismetastock@xxxxxxxxxxxxxxx]
> On Behalf Of Ed Hoopes
> Sent: Monday, February 27, 2006 11:29 PM
> To: equismetastock@xxxxxxxxxxxxxxx
> Subject: [EquisMetaStock Group] Re: Why 1~3% risks for investment ?
>
>
>
> 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@>
> 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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