Wednesday, February 15, 2006

Risk Management - Position Sizing

One of the most difficult to understand and misused terms in trading is risk management. Several books will tell you how you should enter and maybe touch on how you should exit. Very few touch on how much money you should risk on a trade. When you treat your trading as a business you allocate risk to each position. How much money you risk is determined by your risk tolerance, however most professional managers tend to use 1-2% of total equity to determine position size. Since I have a smaller account size I bump it up to around 5%. The reason for using such a small risk percentage is to live another day. You can't continue trading if you've bet the wad on a bad trade. Now when you limit your risk to 2% per position you can lose many times without losing it all. The probability of this happening is quite low. I can lose roughly 15-20 times in a row before I go broke. The good thing is that I win approximately 50% of the time. So the probability of me losing 20 times in a row is about .0000009.

So lets say I want to buy ANTP near its 50 Day Moving average. When I wanted to buy it, it was trading around 16.00. Let's say according to my rules I determined that if it will goes below its 50DMA of around 15.00, then I will sell. So my risk is $1 on a position that costs me $16 plus commission and any slippage. Let's say commission is $10 and slippage is .5% or $0.08 on either side. My total equity is 15,000. To determine my proper position size I start with my total equity.

Total Equity = $15,000
Position Risk (2% of total equity) = 15,000*.02 = $300

$300 is the amount of money I'm willing to risk on the trade. Next, I'm going to look at the costs of the transaction.

Commissions both ways: $20
Slippage: .5%
Buy Price: 16.00 + .5% = 16.08
Stop Price: 15.00 - .5% = 14.92

The basic equation is TotalRisk = Commissions + (Buy Price -Stop Price)*Position Size
My costs will be $300 = $20 commission + (buy price with slippage - stop price with slippage)*Position Size

$280 = (16.08-14.92)*PositionSize
Position Size = 241 shares
Position Equity Size = 241*$16 = $3856

When I place my order I will place a 241 share order at $16.00 and know that my stop is going to be at $15.00. To be even more sophisticated you could place a cost for some type of catastrophic loss, like one of your positions dropped 40% overnight without you being able to get out. Some of these calculations will be slightly different if you are using leverage or wider stops, but the same idea is still there. Determine your risk before you trade. This is your exit plan and you should stick to it if you have a hope of consistently taking profits from the market and staying in the game. This is the model that I started using recently and it has helped me become more consistent and businesslike with my trading. There are other models out there and I may post about them later.


jontait said...

Cool post. The best discussions I think I ever have about the market are all about risk management. I'd like to add that the probablility of you going broke is actually much greater than .0000009, remember the fat tailed probability distributions! In other words, when it rains, it pours. And let's not forget the natural human tendancy to compound errors.

Jim said...

Crap... But my professors said that the market is based on normal distributions. :) Thanks for the comment. I guess I should fix that then.

Chris Perruna said...

Excellent post once again! I see you have been studying Tharp. I recommended his book last week on my blog and feel that this is a good post to link to that post so I will. Keep up the great work!


Jim said...

Thanks for the kind words Chris. I haven't actually read Tharp, but I've read about traders that use some of his teachings. I got to thinking about what their ideas of risk management were and then put pen to paper running calculations and such. This is what I came up with and it made great sense.