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Money & Risk Management & Position Sizing Strategies To Protect Your Trading Account - YouTube
Channel: The Secret Mindset
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Traders spend much of their time looking at
charts and analyzing, using technical or fundamental
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analysis, or a combination of both.
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While these indeed are very good things to
spend time on, not all traders take the time
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to focus on, risk management, and more specific,
position sizing.
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I see a lot of new and old traders or investors
which trade, only to have their accounts blown
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up by taking random positions, with no plan
whatsoever.
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Proper position sizing is a key element in
risk management and can determine whether
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you live to trade another day or not.
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Basically, your position size is the number
of shares you take on a trade.
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It can keep you from risking too much on a
trade and blowing up your account.
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Without knowing how to size your positions
properly, you may end up taking trades that
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are far too large for your account.
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In such cases, you become highly vulnerable
when the market moves even just a few points
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against you.
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Your position size, or trade size, is more
important than your entry and exit when trading
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or investing.
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You can have the best strategy in the world,
but if your trade size is too big or too small
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you'll either take too much or too little
risk.
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So, how do you prevent yourself from risking
too much?
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How do you know the right quantity to buy
or to sell when you initiate a position?
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Let鈥檚 say you have $10,000 in your account
and there鈥檚 a stock valued at $100 you like
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and want to buy.
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Do you buy 100 shares, 10 shares, or some
other number?
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This is the question you must answer鈥攈ow
to determine your position size.
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If you decide to spend your entire account
balance and buy 100 shares, then you will
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have a 100% commitment in this stock.
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And that鈥檚 not indicated.
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Also, in taking a position that represents
a large portion of your total portfolio, there
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is also the opportunity cost involved.
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You would have to pass up other trades that
you may have liked to enter.
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Position sizing is a critical issue that a
trader needs to know beforehand and not do
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on the fly.
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It鈥檚 as important as picking the right stock
or currency to invest.
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Newer traders or investors like to calculate
how much they could make on the upside, how
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much money they could potentially make, and
focus less on how much money they could potentially
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lose.
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There are several approaches to position sizing,
and I will run down some of the more popular
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ones.
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The first one, and the most common one: Fixed
percentage per trade
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Position sizing can be based on the size of
an overall portfolio.
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This means a percentage of that overall capital
will be predetermined per trade and will not
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be exceeded.
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That could be 1% or even 5%.
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This fixed percentage is an easy way for you
to know how much you are buying when you buy.
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To use a simple example of fixed-percentage
position sizing, take again a $10,000 account
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size and a $100 stock.
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If you take a simple 1% position based on
your account size, that comes down to a single
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share.
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You may be thinking you are no better off
than a person with a $100 account buying one
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share.
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The difference is that the $100 account holder
has a 100% position size while the $10,000
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account holder is putting just 1% at risk.
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Which position size allows a trader to sleep
better at night?
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Of course the second one.
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Position sizing helps control risk.
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A 1% hard limit on each trade allows you to
tolerate many losses in search of profits.
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Protecting your capital is your primary job.
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Your secondary job is allowing room in your
portfolio to find other trading opportunities.
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The fixed percentage amount is an easy approach
to accomplish this.
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The second risk management approach involves
fixed-dollar amount per trade
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This approach also uses a fixed amount but
this time it鈥檚 a fixed-dollar amount per
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trade rather than a percentage of the actual
portfolio.
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This involves choosing a number.
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Again using that same $10,000 portfolio as
an example, say you decide you won鈥檛 spend
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any more than, say, $200 on any one trade.
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For traders with small account sizes, this
can be an attractive approach because it limits
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how much you can lose.
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However, it also limits what stocks you can
buy.
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You will have to rule out some securities
based solely on their price.
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Of course, this is not necessarily a bad thing.
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The third approach: Volatility-based position
sizing
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A more complex approach but one that allows
for more flexibility is position sizing based
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on the volatility of the security you plan
to purchase.
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It鈥檚 more dynamic because it doesn鈥檛 treat
each stock the same.
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This approach allows you to really drill down
and exercise finer control over your portfolio.
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For example, growth stocks will invariably
be more volatile and that volatility will
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be reflected in your portfolio.
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To reduce the overall risk of your portfolio,
you would buy less of higher volatility stocks
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than you would buy lower-volatility stocks.
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You can measure volatility with something
as simple as a standard deviation over a given
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period, say, 15 or 10 trading days.
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Then, depending on the deviation, you adjust
the amount of shares you buy when you initiate
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a position.
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This allows lower-volatility stocks to have
more weight in your portfolio than higher-volatility
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ones.
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Position sizing based on this ideology lowers
overall volatility within a portfolio.
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This strategy is frequently used in large
portfolios and I use it personally in my own
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portfolio.
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Even longer-term traders and investors face
position sizing questions.
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For them, when the price of a security they
are holding goes down, it represents more
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value.
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Adding to their position in this case is referred
to as averaging down.
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Long-term traders can decide to average down
using similar position-sizing approaches,
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by risking either a fixed-dollar amount or
a percentage amount when the stock trades
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down.
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You can use standard deviation here as well
to help figure out that amount.
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Averaging down needs to be used with caution,
because if your analysis is wrong, at some
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point you鈥檒l be in a position which is no
longer worth holding.
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You don鈥檛 want to average down to zero by
buying all the way down.
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Some additional common sense risk parameters
seem worth mentioning and may be incorporated
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into your trade plan.
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For example, to be safe, you must be able
to accept losing on any given trade and to
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be able to survive taking losses on ten consecutive
trades.
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And those ten consecutive losses should not
exceed a total 25 percent drawdown.
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This means that no more than two percent of
the portfolio should be put at risk on any
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particular trade.
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Once you figured out how much you are comfortable
losing, a stop loss level for each trade should
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be determined and placed in the market.
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A seasoned trader will generally know where
to put their stop loss orders after having
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optimized their trading plan, and chart analysis
is often performed when setting stop loss
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levels.
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Two rules of thumb should be followed when
you use stops to manage risk on your positions:
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First鈥ever adjust the stop loss to arrive
at a desired position size, but instead adjust
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the size of the position to meet your risk
level and desired stop loss order placement
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based on your analysis.
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Second鈥rade using the same risk parameters
on every trade regardless of the distance
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of the stop loss.
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Avoid putting more money at risk to use a
wider stop, and avoid risking any less money
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on a stop closer to the trading level.
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Adjust your position to meet your predetermined
risk levels.
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By now, I hope you realized that correct position
sizing is crucial.
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You should always consider how much you buy
when you buy, and also, know how you came
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up with that number.
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Regardless of your account size, take the
time to come up with a consistent approach
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that matches your trading style.
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And then stick to it.
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You can incorporate flexibility.
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For example, if you are willing to take more
risk with your portfolio, you can dial up
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the percentage you use.
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Sound money management techniques can help
make an average trader become better, and
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a good trader become great.
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For example, a trader that is only right half
the time but gets out of losing trades before
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the loss becomes significant, and knows to
ride winners to a substantial profit, would
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be way ahead of most others who trade with
no clear plan of action whatsoever.
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And you have to find the right balance because
if you risk too little and your account won't
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grow, and if risk too much and your account
can be destroyed in few bad trades.
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Until next time.
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