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Risk Management |
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When you enter a trade, you accept a certain amount of risk . A simple definition of this risk is the maximum amount of money you could potentially lose should the trade not move in your favor.
Having an understanding of your own tolerance for risk will play a large part in determining the success you will enjoy in the market.
Do you know the exact amount of risk you accept for each trade?
Sounds like a simple question. Without knowing the answer to this question before you enter a trade means you could potentially lose your whole investment.
Risk management is a process by which the trader acknowledges the potential risk being adopted for the trade.
The importance of setting an acceptable amount of risk for each trade will help to protect your capital, allow you to calculate the most optimal position sizes and above all provide motivation to exit the trade should your risk setting be reached.
This motivation is important when trying to combat the negative effects of trading psychology.
Do you know when to exit a trade?
If you don't know when to exit a trade, your potential loss is undefined. Would you make an investment without knowing the amount of money you could potentially lose?
I didn't think so....
For this reason alone it's important to understand and accept an agreed amount of risk with each trade you take.
The peace of mind you will gain by knowing the exact amount of loss before you even enter the trade will be worth the effort of understanding money management.
Defining your risk can be as simple as a fixed percentage of your capital or a percentage of the entry price to a fixed dollar amount.
The way you define risk is totally up to you. Let's have a look at an example.
John has $50,000 in total to invest in the share market.
He decides that on any one trade he does no want to risk more than 1.5% of his total capital. He has settled on 1.5% as he is most comfortable living with this amount of risk.
John identifies a share and purchases 10,000 at $2.50. John has spent a total of $25,000 on this trade and has accepted a total of $750 risk for this trade.
John sets a stop loss at $2.42, this means he will sell all 10,000 shares should the price drop to $2.42.
Selling at this price would equate to a loss of $750.
In the above example, John pre-determined the amount of money he was willing to risk on any trade, before he entered it.
This is the basis of trade risk management. The first important step in this process is to understand you are taking a risk when entering the market and to pre-determine the amount of risk you are willing to accept.
Just remember to ask yourself this question:
How much money can I accept to lose if this trade does not go in my favour?
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Risk Analysis Techniques (97KB) |
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Author: |
Ian Hawkins |
| Date: |
1998 |
| Synopsis: |
A must read for any Risk management Professional as a very descriptive review of the technique for risk analysis has been given in it. There have been numerous number of references also given which extends the concepts much further.
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| Complexity: |
Advanced |
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Managing your Money (280KB) |
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Author: |
Gibbons Burke |
| Date: |
July 2000 |
| Synopsis: |
In this activetradermag article from July 2000 Gibbons Burke goes through the topic of managing your own money. This is a great introductory article on the importance of money management and portfolio management. |
| Complexity: |
Beginner |
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Why it's so difficult for most people to make money in the markets (123KB) |
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Author: |
Van K Tharp, Ph.D |
| Date: |
Unknown |
| Synopsis: |
In this article Dr Van Tharp explains the reason why so many traders fail to make money in the markets. A great article on money management and position sizing. |
| Complexity: |
Beginner |
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The Stop Loss |
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The stop loss acts as a price at which you will exit the trade, this price is usually determined before the trade is entered. The stop loss is the point at which you will exit the trade "no questions asked".
A stop loss will help preserve your capital to make sure you can trade another day.
If the trade stop is hit by the current price, exit the trade "no questions asked".
A stop loss is usually calculated before a trade is opened. Various trading systems will employ the use of a trailing stop loss to signal an exit on the trade.
Trailing stop losses ratchet up as the share price moves up, this has the effect of locking in profits once the trade has moved in your favor.
Remember, a stop loss is simply a mechanism which signals the exit of a trade.
A basic example of employing a stop loss is provided below.
John has decided to buy $20,000 worth of "XYZ" shares with his $50,000, he has decided that he does not want to risk more than 1.5% of his capital on the trade. The current share price of "XYZ" is $2.00.
John calculates that he is going to risk $750 on this trade (1.5% x $50,000). John then buys 10,000 shares of "XYZ" at $2.00.
John sets his stop for this trade to equal a loss of $750 (i.e. the price which will realize John a loss of only $750). John's stop for this trade is $1.925 (($20,000 - $750) / 10,000), if the share price where to drop to $1.925, John would immediately sell his holding in "XYZ".
The trailing stop loss is a stop loss which moves in accordance to the share price and provides an exit point for the trade.
If you can imagine the share price constantly rising, you would want to preserve some of the unrealised profit. You can do this with the use of a trailing stop loss, the same concept of a stop loss still applies. That is, the trade is immediately exited when the current price reaches the trailing stop loss price.
The most important thing to remember about the stop loss is its importance in signaling an exit point for any trade. Many believe the exit is far more important than the entry, whichever way you look at the stop loss it will:
 Determine when you should exit the trade
Lock in profit or fixed loss for each trade
Preserve your capital to ensure you can trade another day!
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Importance of Exits |
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Author: |
Chuck LeBeau |
| Date: |
Unknown |
| Synopsis: |
The outcome of every trade is dependent on the exit. If we enter in a timely fashion and then exit poorly, the trade is likely to be a loss. If our entry happens to be poor but our exit is good we might still salvage a profit. The exits, not the entries, determine the outcome of our trades. This lesson about exits is easily demonstrated. |
| Complexity: |
Beginner |
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Planning Your Losses |
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Author: |
Brett Steenbarger |
| Date: |
Unknown |
| Synopsis: |
(April 14, 2002) - I received dozens of emails following my recent chatroom class with Linda Raschke. The question I heard most often concerned the setting of stops. Specifically, traders were interested in learning how I set my stops, especially with trades that lasted an average of less than 30 minutes. |
| Complexity: |
Beginner |
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Position Sizing |
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The concept of position sizing is to determine the optimal amount of units to purchase for the trade.
Correct position sizing is a little known concept amongst the majority of traders/investors. It has been statistically proven that a random entry with correct position sizing will generate profits. From these statistical results the entry into a trade is clearly not the most important factor to success.
After you have determined an acceptable amount of risk for a trade you can calculate the optimal number of shares you wish to purchase based upon various money management models which employ the use of risk in their position sizing calculations.
An example of a position sizing calculation involving risk is shown below.
John has $50,000 to invest in total, he is willing to risk only 1.5% of this amount in every trade. He is looking to buy some "XYG" shares at their current share price of $3.45. He has also set his stop price at $3.10. How many shares should John buy?
First let's calculate the amount of risk in dollar terms (1.5% x $50,000 = $750). This $750 will equate to the amount of dollars lost if the share price drops from $3.45 to $3.10. Applying simple mathematics we can calculate the number of shares to purchase ($3.45 - $3.10 = 35c), $750 / 35c = 2,143.
John has to buy 2,143 shares of "XYG" at $3.45 to satisfy the position sizing equation.
There are many different methods available to calculate position sizes. Stator includes an Advanced Position Sizing calculator which contains many of the most popular money management models. Using this calculator makes it easy to employ successful position sizing techniques directly into your trading.
You can download your very own FREE Money Management Position Size calculator by following this link. [Take me to the FREE Calculator]
Example position sizing models:
The following position sizing models are some of the more popular models used by many traders and investors, you may even find that you have used various models when determining the optimal number of units to purchase. |
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Fixed Units |
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A very simple model which calculates the total purchase price for the parcel. This model cannot be described as a position size model as the number of units are known prior to calculation.
For example, an application of this model would be the purchase of 10,000 shares of ABC at $3.50. Applying the Fixed Units model we calculate that the total parcel size for this purchase is going to be (10,000 x $3.50) $35,000 before any additional costs such as brokerage etc.
Formula:
Total Parcel Cost = Quantity x Price |
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Fixed Dollar |
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This is the Fixed Units model in reverse. Another simple application of a position size model. The Fixed Dollar model calculates the number of units to purchase based upon knowing the price and total parcel cost.
For example, an application of this model would be to decide to invest a total of $15,000 in ABC stock. The current price of ABC stock is $3.50. Using the Fixed Dollar model we can calculate the number of units to purchase.
The number of units to purchase is ($15,000 / $3.50) 4,285. You will always have to round the number of units down to the nearest whole number.
Formula:
Quantity = Total Parcel Cost / Price |
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Fixed Dollar & Units |
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This is a unique model which calculates the price to be paid. Rather than calculate the quantity we use this model to determine the purchase price when the only items we know are the quantity and the total parcel cost.
For example, an application of this model would be to decide to invest a total of $15,000 in ABC stock and purchase 10,000 units. Using the Fixed Dollar & Units model we can calculate the purchase price required to fulfill this order.
The purchase price for this parcel is ($15,000 / 10,000) $1.50. This model is best utilised when you enter a parcel into a portfolio management program, this is usually performed after the parcel has been purchased so it acts as a reconciliation against the contract note. This model is only available within Stator.
Formula:
Price = Total Parcel Cost / Quantity |
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Position Sizing Primer and FREE calculator instructions
(eBook available from calculator download location) |
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Author: |
Anthony Nosek |
| Date: |
August 2004 |
| Synopsis: |
Learn how to use the FREE Money Management software that we have available on this site to calculate position sizes using popular money management models. If you haven't got your FREE Calculator [Click Here] to download now! |
| Complexity: |
Beginner |
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Some Practical Thoughts on Money Management |
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Author: |
Chuck LeBeau |
| Date: |
Unknown |
| Synopsis: |
We get a lot of questions about various complex money management (MM) formulas and our preferences. We don't comment on this subject very often because money management is such a personal issue that it would be impossible to give any universal advice that would be specific enough to have value. Everyone seems to have different goals and tolerances for risk, not to mention varying amounts of capital for trading. |
| Complexity: |
Beginner |
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Fixed Percent Units |
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This model will calculate the optimal number of units to purchase based upon a specified percentage of your overall trading/investing float. The Fixed Percent Units model is a further extension of the Fixed Dollar model described above. This model introduces two new concepts, the total trading/investment float and the float percentage.
Total trading/investment float.
This is predominantly defined as the total amount of funds you have set aside for trading, irrespective if you have any money allocated to trades or not.
Float Percentage (Float %).
This is a percentage of your total trading/investment float that you have decided to allocate to this trade.
For example, you have decided to invest $100,000 in total. Of this $100,000 you have decided to allocate 5% to purchase some stock in ABC. The share price for ABC is currently at $3.50.
First we determine that the total purchase cost for this trade is going to be (5% of $100,000) $20,000. Applying this to the model we can calculate that we need to purchase ($20,000 / $3.50) 5714 shares.
Formula:
Quantity = (Total trade/investment float x Float %)/ Price |
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Fixed Dollar Risk |
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This model will calculate the optimal number of units to purchase based upon a specified risk amount for the trade. This money management model introduces two new concepts called the Stop Loss and Risk Dollar.
Stop Loss.
As previously mentioned above the stop loss acts as a signal to exit the trade. A stop loss can be a price which will trigger an immediate exit from the trade. Stop losses help to preserve capital and provide a calculated approach to trade management which helps many traders/investors overcome the effects of trading psychology. It is essential for this money management model for the stop loss to be determined before the trade is entered.
Risk Dollar.
The risk dollar equates to the total amount of money which is going to be lost if your stop loss is activated. The stop loss is a price which triggers an exit from the trade. Integral to this model is the acknowledgement that the stop loss is a good trigger and it will result in you losing a certain amount of your money. Always remember that a stop loss will help preserve your money so that you can trade another day.
For example, you have decided to purchase some shares in ABC with the current share price at $3.50. You have decided that you are willing to risk $1,500 on this trade and set an initial stop loss of $3.20 for the trade. The Fixed Dollar Risk model will calculate the number of units to purchase which will result in losing only $1,500 if the stop loss is triggered.
The Fixed Dollar Risk model does this in the following way.
1. It determines the price difference between the share price and the stop loss price ($3.50 - $3.20) = $0.30.
2. It will equate the $1,500 to this 30c. ($1,500 / $0.30) = 5,000
The optimal number of units to purchase is 5,000.
Testing the model
You can perform a simple test on this model to check its validity. It is also useful to do this until you become more comfortable with this method of calculating positions. To test is a simple matter of determining the total parcel cost which in this example is ($3.50 x 5,000) $17,500. Secondly determine the total parcel cost at the stop loss value which is ($3.20 x 5,000) $16,000. Lastly the difference between these two amounts should be the risk dollar.
Formula:
Quantity = Risk Dollar / (Current Price - Stop Loss) |
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Fixed Percent Risk |
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This model is a further extension of the Fixed Dollar Risk model. This model uses a percentage of the total trade/investment float to determine the risk dollar. This approach is useful if you intend upon reinvesting all profits back into the market (pyramid profits) as the risk dollar will increase or decrease relative to the total amount of funds you have to invest.
Risk Percentage (Risk %).
This value represents the percentage of your total trade/investment float that you are willing to risk on each trade. Similar to the risk dollar which is a static value the risk percentage is fluid and will adjust to the amount of money you wish to invest.
An example of this is if you have decided to purchase some shares in ABC with the current share price at $3.50. You have decided that you have $100,000 to invest in shares and are willing to risk 1.5% on this trade. You set an initial stop loss of $3.20 for the trade. The Fixed Percent Risk model will calculate the number of units to purchase which will result in losing only $1,500 if the stop loss is triggered.
The Fixed Percent Risk model does this in the following way.
1. It determines the price difference between the share price and the stop loss price ($3.50 - $3.20) = $0.30.
2. It determines the risk dollar based upon the total trade/investment float and the risk percentage value you have defined. In this example it is ($100,000 x 1.5%) $1,500.
3. It will equate the $1,500 to the 30c difference. ($1,500 / $0.30) = 5,000
The optimal number of units to purchase is 5,000.
Testing the model
You can perform a simple test on this model to check its validity. It is also useful to do this until you become more comfortable with this method of calculating positions. To test is a simple matter of determining the total parcel cost which in this example is ($3.50 x 5,000) $17,500. Secondly determine the total parcel cost at the stop loss value which is ($3.20 x 5,000) $16,000. Lastly the difference between these two amounts should be the risk dollar, which in turn will be the risk percentage of the total trade/investment float.
Formula:
Quantity = (Total trade/investment float x Risk %) / (Current Price - Stop Loss) |
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Fine-Tuning Your Money Management System (174KB) |
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Author: |
Bennett A McDowell |
| Date: |
Unknown |
| Synopsis: |
Acknowledge the risks in trading the markets by making sure your money management system is sound. |
| Complexity: |
Beginner |
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Position Sizing Effects on Trader Performance (144KB) |
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Author: |
Johan Ginyard |
| Date: |
2001 |
| Synopsis: |
A masters thesis written by the renowned Johan Ginyard. This thesis discusses at length the effects of various position sizing models on traders. A very interesting white paper on the power of money management and the performance results obtained when applied to various trading systems. |
| Complexity: |
Moderate |
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Money Management (1,503KB) |
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Author: |
Ryan Jones |
| Date: |
March 1999 |
| Synopsis: |
Ryan Jones introduces the concept of money management in this extensive book. Suitable for all readers this book covers all the basics with enough here to stimulate the thought of advanced traders. |
| Complexity: |
Moderate |
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