Most losing traders spend too much time on entry and exit points. Before you going looking for the next holy grail, let’s focus first on stopping the bleeding.
The bleeding is the trader’s poor assessment of risk. Have you lost more than 2% on a trade before? If so, I’m talking to you. You need to focus on developing an appropriate position size for your trades.
Maximum Tolerable Risk
There are two types of risk associated with trading: capacity for risk and tolerance for risk. Capacity for risk is the total amount that a trader can lose before wiping out his account. Basically, it’s the amount of money in your account.
Tolerance for risk defines how much a trader can stomach losing and still sleep at night. When determining the maximum risk we are willing to take for a given trade, I factor in both of these types of risk.
Even if the trade is an immediate loser, we will still be a long way from our capacity for risk or tolerance for risk limits. A trader’s primary goal should be to survive to trade another day. Keep this in mind when developing trading systems.
In order to calculate the maximum tolerable risk for a given position, you must first decide how much of your equity that you are willing to risk on a single trade. I have seen this number range anywhere from 0.25% to 2.5%, but 1% seems to be the most common recommendation. The key here is to go with a number that will keep your trading above your capacity for risk and tolerance for risk even during losing streaks. It is always better to lean towards the conservative side.
The maximum risk for a single trade is calculated by multiplying the percentage you are willing to risk by your trading capital.
Position Sizing Formula
The goal with this formula is to smooth out the volatility between different securities so that each position you take will have the same impact on your overall portfolio. To do this, we must adjust for the historic volatility of each position.
Accounting for volatility makes each position have the same influence, good or bad, on the results. This adjustment can level the playing field by making lower volatility securities more appealing and higher volatility securities less dangerous.
In order to determine the an appropriate position size accounting for volatility, divide the our maximum tolerable risk by a multiple of the Average True Range (ATR). For the examples in this post, I will use a multiple of 2, which will allow the position to move double its average daily move without going past the maximum tolerable loss. This multiple can be adjusted up or down depending on your own personal appetite for risk.
Max Risk / (X * ATR) = Position Size
Traders can adjust the risk number or ATR multiple to achieve any desired amount of risk, but should always backtest and lean towards the conservative side. Remember, the goal is to live to trade tomorrow. It is also important to set an initial stop loss, which can also be done using ATR.
Position Sizing Example
Assume that we have a $10,000 portfolio and that we are willing to risk 1% of that portfolio on any given trade.
In this chart, MSFT has a recent closing price of 31.79 and an ATR of 0.704. Take the $100 we are willing to of risk and divide it by 2 ATRs to calculate our position size.
$100 / (2 * .704) = 71.023
Since we are not able to trade partial shares of MSFT, we will round down in order to stay conservative. This means we can purchase 71 shares of MSFT for a total commitment of $2257.09.
In this chart, you can see that KORS has a recent closing price of 56.12 and an ATY of 2.03. Using the same formula, we will take our $100 risk amount and divide it by twice the ATR.
$100 / (2 * 2.03) = 24.63
We can purchase 24 shares of KORS for a total commitment of $1346.88.
Since KORS is the more volatile company, we will be purchasing much less of it. MSFT has a history of moving slower, so we can be more comfortable taking a larger position in it.
Keep in mind that this is simply an example using round numbers and that investing 22% of your portfolio in MSFT or 13% in KORS might be more exposure than you are willing to accept. In that case, you can adjust the maximum tolerable risk or ATR multiple to get to a position size that works best for you and your trading strategy.