Wednesday, May 5, 2010

How Much Should I Risk On My Next Great Trade Idea?

In my mind there are two types of traders, the short term trader, including those looking for profits in a few minutes, hours, days, or weeks, and the long term investor who expects to hold a position for at least a year if not longer. The primary differences between the two are taxes, the former is likely to have gains taxed as income and the latter as long term capital gains, and diversification. The shorter term trader might be more concentrated in a particular sector where as the long term trader is likely to seek diversification across sectors and asset classes.

But what do they have in common?

In both the short and long haul, whether you are trading stocks, bonds, commodities, FOREX, or anything else, traders have to answer the question of how much they should risk on a given trade. This is a concept that Van Tharp discusses in his book Trade Your Way to Financial Freedom, however I found that I had to do a lot of thinking to really understand his idea. Hopefully I will have done some of the thinking for you because this is a valuable tool to define risk levels that are acceptable to you whether you are a short term trader or a long term investor. Additionally, the idea is applicable to stocks, options, or whatever your chosen investment vehicle.

I am going to assume that you already have a method for selecting your investments (other than throwing darts). That being the case, the first step is to define the level of risk you are willing to take either on a dollar basis or a percentage basis. In other words, using round numbers, let's say that you have $100,000 of trading capital. How much of that are you willing to risk on any given trade and what does that mean anyway?

Clearly, no matter how great your trading idea, it is never a good idea to risk everything on a single trade, so you need to define some parameters. For our discussion we are going to define an acceptable level of risk as 1R (this is Tharp's chosen variable as well, but it makes sense since we are discussing Risk), and this will equal 1% of trading capital or $1,000. A typical response might be, "Well there aren't many investments that I can make for $1,000." This is probably the most frequent misunderstanding of the idea. The question we are answering is how much risk to take and the size of that position not the dollar value of the investment.

For example, if you purchase 1,000 shares of a $10 dollar stock, you have invested $10,000 (we not going to take margin into account for simplicity sake, but you should when you apply this technique). Hopefully, when you made this purchase you did not do so with the attitude that you were going to hold on come hell or high water and unless the stock goes to $0 you are going to stay in until you make a profit. You probably have some kind of stop (if you don't you should, but that is a different topic), either mental or a real stop loss order. A stop loss order is an order that is placed below the market when you are on the long side in which a sell order is generated when a stock falls to that specified price.

In this case, we are willing to risk 1R, or $1000 so we should have a stop at $9 which would be triggered if the stock falls by $1 from the purchase price. While the trade might lose 10%, because of the stop, only 1% of trading capital was risked. Let's work with this concept a little more and see how it might apply to the different types of traders.

The Short Term Trader

Leveraged ETFs are favorite vehicles for short term traders and let's say that Trader Joe (no relation to the guy with the grocery store) has a very simple method for entering his trades: when the 10 period moving average crosses the 20 period moving average on an hourly chart he buys. The chart of the FAZ was snapped a few days ago and the trader had ample time to enter around $11.90. Looking at the hourly chart, he determines that in a worst case the FAZ, which can move quickly, should find support around $11.10, but if it breaks this level, Trader Joe feels that it is probably going lower and wants out. In all likelihood, as a short term trader, he is going to be watching this ETF closely and may be moving his stop higher in a methodical fashion or may exit on a crossover in the other direction. The exit strategy is extremely important as well, but it is not today's topic.

So we have the entry price ($11.90), stop level ($11.10), and our risk parameter of 1R (1% of trading capital or $1,000), now we can determine the correct position size for this trade.

$1000 / (11.90 - 11.10) = 1250

Dividing the amount you are willing to put at risk by the potential adverse price move provides you with the correct position size. Now, it is important to stick to your guns when you have an adverse move and not let a 1R loss turn into some greater multiple of R.

The Long Term Investor

Investor Sue also uses a moving average crossover technique, but she looks for long term trends. For this example, she was alerted to TPX when the 50-day simple moving average (SMA) crossed the 200-day SMA in April 2009. Rather than jump in on the crossover, however, she likes to see that a trend has some potential. When the stock successfully bounced off the 50-day SMA in late May 2009, she decided to get in.

Now, Investor Sue, who also does not wish to risk more than 1% of her $100,000 of investment capital, could not now her actual entry price when she had to make her position sizing decision, but she estimated that it would be around $12. Although she used the test of the 50-day SMA to confirm the trend, she feels that a violation of the 200-day SMA would indicate that the trend has failed and she would need to get out of TPX. She determined her position size as follows:

$1000 / (12 - 8.57) = 291.55

Obviously, she can't buy .55 shares and she prefers round lots, so she rounds her order up to 300 shares. By the time Investor Sue finishes doing the math and gets her order in, she ends up with an entry price of $12.30. Although she is risking a little more than intend (($12.30 - $8.57)*300 = $1,119), she feels that this is reasonable within parameters.

Wrapping Up

You probably noticed that there is a significant difference in the size of Trader Joe's and Investor Sue's investment value, $14,875 (1250*$11.90) and $3,690 (300*$12.30). This is consistent with their respective trading styles (frequently in and out of the market vs. planning a diversified portfolio) and neither is risking more than 1% of their trading/investing capital given that they have planned for a worst case scenario. Of course many people do not have do not have $100,000 of capital to play with, but this rule of thumb can greatly improve your ability to manage risk in your portfolio regardless of the size of your account or your trading style. So what are the things to remember?

  1. Determine a percentage level of risk that you are willing to take on any given trade. While I used 1% here as an example, you have to determine what you are comfortable with. A word of caution, everyone makes bad trades, hopefully not as many as good ones, but if you choose a risk level that is too high it only takes a few consecutive mistakes to wipe out a big chunk of your capital. 1-2% is probably a good guideline.
  2. You need to know when to get out of a bad trade and you should know this before you get into any trade, whether you are going long or short, or trading stocks, ETFs, options, or frozen orange juice futures (Beware of Beeks!). Don't let a 1R loss turn into something ugly.Size your position properly. You need the dollar value of risk, an estimated entry price, and the bailout price. This will allow you to get a good handle on position sizing and improve your ability to manage risk.

  3.     .     Size your position properly.  You need the dollar value of risk, an estimated entry price, and the bailout price. This will allow you to get a good handle on position sizing and improve your ability to manage risk.

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