This Journal posting and the next couple will be devoted to answering these specific questions posed by Simon to my 27th March journal post with the key questions repeated below: http://blog.sharewealthsystems.com/?p=2380&cpage=1#comment-15666
“It appears that the definition of the level of risk, both trade risk and portfolio risk, is central to adopting a robust and reliable trading regimen. Because it seems that you really can’t trade consistently or reliably without defining or calculating the risk of a trade, I’d love you to outline and explain how you assess or define the risk of a particular trade.”
“I’d love you to go back one stage further and explain how to assess, or at least what factors to consider in determining, a stock’s trade risk. Obviously volatility is crucial but is that the only factor that determines your calculated trade risk?”
Simon has obviously grappled with trying to solve this himself which is why he has gone straight to one of the key questions that needs to be answered: how to best calculate a stock’s trade risk.
To make it clear, we are talking about the Percent Risk per Trade position sizing model. This is by no means a new model. SPA3 uses the Percent Risk per Trade model to calculate its position sizes for each trade. But we have implemented a key research-based feature that is rather unique when determining a stock’s trade risk. I will explain how we have done this in this blog series.
Also, to assist in answering the key question of what percentage to risk per trade I will explain how we have gone about finding the answers in a rigorous research-based manner rather than by guessing, using live trading trial and error or merely using popular consensus.
Firstly, to save readers looking it up elsewhere on the internet I have repeated the calculation of the Percent Risk per Trade model here. These are the steps required to calculate the quantity of shares to purchase using the Percent Risk per Trade model, and hence the dollar position size:
Calculate the maximum allowable Risk per Trade. This is x percent of your Portfolio Value. The Risk per Trade is a dollar value and should include brokerage.
Determine where your Stop Loss is for the trade. This is the price at which the trader will exit the trade. In essence, Simon is asking how this should be determined on a consistent basis.
Calculate the Dollar Risk per Share, or the stock’s trade risk as Simon has put it, by
subtracting the Stop Loss from the buy price.
Calculate the Quantity of Shares to purchase by dividing the maximum allowable Risk per Trade by the Dollar Risk per Share.
The Position Size is then the Quantity of Shares multiplied by the buy price.
Here’s an example. Assume an initial trading capital of $50,000 and brokerage of $20 per trade.
Assume a 2% risk per trade. The maximum allowable Risk per Trade is 2% * $50,000 = $1000 per trade, less brokerage = $980.
- Determine the Stop Loss. If a stock is priced at $10.00 and the trade demands a Stop Loss of, say, 10% then the Stop Loss is $9.00.
- The Dollar Risk per Share, or trade risk, is $10 – $9 = $1.00.
The Quantity of Shares to purchase is $980 / $1.00 = 980 shares.
The Position Size = 980 * $10 = $9,800.
From this calculation it should be obvious that the trade risk, the Dollar Risk per Share, plays a huge role in determining the position size and, in turn, where the Stop Loss is placed plays a huge role in determining the trade risk. For example, if the Stop Loss was at $9.50 and therefore the Dollar Risk per Share was $0.50, the position size would be double the size at $19,600, which would be too big for a $50,000 portfolio.
Next week I will look at a detailed example that will expose some of the problems associated with determining where to place the Stop Loss and the effect that it has on a position size.
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