Please also see the discussion on Stops
This is one of the areas that almost killed my trading account. In addition to trading without a stop loss, I was trading position sizes that were far too big for my account. This was great if a trade was moving in my direction but if you add in leverage, the losses were magnified as well and I could easily have been wiped out.
No one ever told me how to determine how much I should buy – certainly I was never told anything other than this kind of consideration “make sure you don’t have more than 60% of your account used for margin” which when you think about it is a totally meaningless statement. The purpose in this ‘educators’ mind was that this would mean you would never get a margin call but told you absolutely nothing about how much would be a good amount to ‘buy’ or ‘sell’.
In the Stops I explained one possible method of determining an appropriate position size. There are however some other considerations.
Let’s assume for now that you have an account balance of $20,000.
The first thing you need to consider is how much of that $20,000 you are prepared to risk on any one trade. Generally, with smaller account balances like this, most beginner traders would probably have a risk size of 2%. As your account balance grows, a lot of traders may find they only risk 1% or even less per trade.
For the sake of this discussion, I am going to pick a 2% risk. This means for any one trade I would be prepared to lose $400. If I had 20 losing trades in a row, assuming I used the same percentage risk on my initial capital, I could lose $8,000 – devastating but it’s not wiping out my whole account and I live to fight another day. The only absolute rule in trading is ‘no money – no play’. In fact, if I lost $400 on my first trade, I should then use 2% of %19,600 = $392 for my next trade and so forth. Equally as my account balance increases I can increase the dollar amount of my risk without increasing the percentage risk.
Now there is another thing here to consider. Let’s say the market has a really bad day like some of the crashes we have seen in the past. As a general rule, we should have a risk on our entire portfolio of some percentage. This is called the portfolio heat. This is the total amount of our account we would wish to lose (ha!) if every single position went bad in one day. Typically many traders would set this at 5%. This is up to your own personal psychology and risk tolerance level. It’s not a rule! (as I said the only rule is no money, no play)
So if you had this same $20,000 account and a 5% portfolio heat rule, this would mean you were prepared to lose $1,000 of your account in one hit. If you have a 2% position size, that would mean you could only have 2 positions.
Now as a position moves in your favour, you can move your stop loss up so that you have less than that 2% at risk. We always value our risk from the entry price of the instrument to the stop loss. So an example. We buy a share for $40 and we have our stop loss at $35. Say it’s our $20,000 account with a 2% risk – this would mean we would purchase $400/$5=80 shares. So if we were stopped out we would sell those 80 shares at $35 and make a loss of $5 per share x 80 shares = $400.
Now however, lets say the stock moves up from $40 and is now $42. We move our stop up from $35 to $37. If we got stopped out at $37, we would lose $3 per share x 80 shares =$240. Our portfolio heat is now 1.2% (if that was our only position – $240/$20,000 expressed as a percentage) So as a position moves in our favour and we move our stop up, we will have portfolio heat available to take on more positions.
Note we only ever value our portfolio to out stops – we do not consider any open profit on the position. ONLY the risk. Open profit is not yours. It’s not yours until you close out the position.
Eventually, all going well, you will have your stop loss above your purchase price – this is called a break even stop. This is then a position you will have a chance of making some money on. The trick is to get your stop to break even as quickly as possible without getting stopped out too quickly so we want to give the position some room to breathe so we don’t set out stops too tightly. See the article on stops for more information.
Some other observations.
- If you are using the ATR to determine your stop loss level, IF using a daily chart, use a daily ATR. If using a weekly chart, use a weekly ATR.
- Using a daily ATR with a weekly chart will generally give you a tighter stop loss level which means you can buy more of the product for the same risk level.
- Tighter stops will mean you are more likely to be stopped out quickly (and lose the amount of risk)
- Wider stops will keep you in a position longer and give the position more room to move. This will also mean you will have a smaller position size.
- When a stop gets to break even, you can widen your stop to a higher ATR multiple as it continues to rise giving it more room to move. It’s instructive plotting different ATR (or other way you determine your stop level) on a chart and comparing.
- Stops don’t just go straight up. They fall back a little and go sideways a little and commence their climb upwards.
Originally posted 2017-05-04 13:37:28.