A so-called investor questioned my trading methods and claimed I would lose 76% if I took 8 consecutive 8% losses. Knowing me, I had to breathe deeply, release the anger from a person who knows nothing about position sizing and teach him a simple math lesson. The following example is simplified to allow you to understand what is happening. In the real world, things are a bit more complicated with commissions, emotions, slippage and the like. What is position sizing?
Position sizing tells you how much to risk on any one trade. Here I will show you how position sizing can allow you to lose 80% of the time while risking a worse case scenario of 3% equity (I typically risk 1% of equity); yet still come out a slight winner. If I start with $100,000 and lose 8 consecutive trades at 8% (only risking 3% of capital with 8% stop loss), this is what it looks like:
$100,000 portfolio
3% risk per trade (I am being extreme here to prove a valid point)
8% stop loss
1st Trade:
Risk will be $3000 = ($100,000*3%)
Amount to Trade at 8% stop: $37,500 = ($3000 / 8%)
An 8% stop loss will cost me $3000 2nd Trade:
Risk will be $2,910 = ($97,000*3%)
Amount to Trade at 8% stop: $36,375 = ($2,910 / 8%)
An 8% stop loss will cost me $2,910 3rd Trade:
Risk will be $2,822 = ($94,090*3%)
Amount to Trade at 8% stop: $35,283 = ($2,822 / 8%)
An 8% stop loss will cost me $2,822 4th Trade:
Risk will be $2,738 = ($91,267*3%)
Amount to Trade at 8% stop: $34,225 = ($2,738 / 8%)
An 8% stop loss will cost me $2,738 5th Trade:
Risk will be $2,655 = ($88,525*3%)
Amount to Trade at 8% stop: $33,198 = ($2,655 / 8%)
An 8% stop loss will cost me $2,655 6th Trade:
Risk will be $2,576 = ($85,873*3%)
Amount to Trade at 8% stop: $32,202 = ($2,576 / 8%)
An 8% stop loss will cost me $2,576 7th Trade:
Risk will be $2,498 = ($83,297*3%)
Amount to Trade at 8% stop: $31,236 = ($2,498 / 8%)
An 8% stop loss will cost me $2,498 8th Trade:
Risk will be $2,423 = ($80,798*3%)
Amount to Trade at 8% stop: $30,299 = ($2,423 / 8%)
An 8% stop loss will cost me $2,423 Total loss after 8 trades: $19,201
This loss totals 19% (minus commissions etc) TRADE #9:
Risk will be $2,351 = ($78,374*3%)
Amount to Trade at 8% stop: $29,390 = ($2,351 / 8%)
An 8% stop loss will cost me $2,351
**This trade ends with a 40% gain: $11,756 = ($29,390*40%)** Original amount: $78,374 + $11,756 = $90,130 TRADE #10:
Risk will be $2,703 = ($90,130*3%)
Amount to Trade at 8% stop: $33,787 = ($2,703 / 8%)
An 8% stop loss will cost me $2,703
**This trade ends with a 30% gain: $10,136 = ($33,787*30%)** Total portfolio worth: $100,266 WOW a profit with 8 consecutive losing trades and 2 winning trades! That is a 20% winning percentage but it gave me an end result of a slight profit! This is how money management works! Please realize that I was using extreme examples to stress the important point of position sizing. Now just imagine have a winning percentage of 40% or greater and cutting some of those losses at less than 8%, your portfolio could easily gain 50% or more in one year with a 40% winning percentage based on simple position sizing! This is how TRUE investors and traders take money out of Wall Street. What does position sizing do when you alter the sell stop? Here are several examples of buying the same stock with a 7%, 15% and 25% sell stop in place with two different size portfolios. The number of shares change but the risk stays the same. In the first set of examples I will use $10,000 and then $5,000 for the second set of examples. In these examples, I will use the simplified approach discussed by Brian Hunt from my first post. Please note that these examples dont consider other variables such as slippage, expectancy, commissions, compounding, etc. Please read the book by Van K. Tharp to study the detailed models of position sizing. I will also note that it is very difficult to employ this position sizing strategy with only a $5,000 stake. In my own experiences, I only bought one or two stocks when my portfolio was starting out with less than $10,000. Besides, I didnt know about position sizing ten years ago! Example #1:
Stock XYZ is trading at $25 per share
Portfolio size of $10,000
Risk Model of 3% per trade (due to a small account)
The stop loss is 7% Risk will be $300 = ($10,000*3%)
Amount to Trade at 7% stop: $4,285 = ($300 / 7%)
Shares to be bought: 171 Example #2:
Stock XYZ is trading at $25 per share
Portfolio size of $10,000
Risk Model of 3% per trade (due to a small account)
The stop loss is 15% Risk will be $300 = ($10,000*3%)
Amount to Trade at 15% stop: $2,000 = ($300 / 15%)
Shares to be bought: 80 Example #3:
Stock XYZ is trading at $25 per share
Portfolio size of $10,000
Risk Model of 3% per trade (due to a small account)
The stop loss is 25% Risk will be $300 = ($10,000*3%)
Amount to Trade at 25% stop: $1,200 = ($300 / 25%)
Shares to be bought: 48 Now I will change the parameters to a 2% risk model with $5000 in the account: Example #1:
Stock XYZ is trading at $25 per share
Portfolio size of $5,000
Risk Model of 2% per trade
The stop loss is 7% Risk will be $100 = ($5,000*2%)
Amount to Trade at 7% stop: $1,428 = ($100 / 7%)
Shares to be bought: 57 Example #2:
Stock XYZ is trading at $25 per share
Portfolio size of $5,000
Risk Model of 2% per trade
The stop loss is 15% Risk will be $100 = ($5,000*2%)
Amount to Trade at 15% stop: $667 = ($100 / 15%)
Shares to be bought: 26 Example #3:
Stock XYZ is trading at $25 per share
Portfolio size of $5,000
Risk Model of 2% per trade
The stop loss is 25% Risk will be $100 = ($5,000*2%)
Amount to Trade at 25% stop: $400 = ($100 / 25%)
Shares to be bought: 16 Using simple math, position sizing will keep you in the game by telling you how much to risk on every trade. Make sure you read my other article on expectancy as it goes hand-in-hand with position sizing. |
