A Primer On Risk Control
A Question of Risk
Risk gets a lot of lip service from traders,
investors, commentators etc, but do you really employ risk management
techniques in your trading? Some traders do, others do not. Most traders
equate risk to the size of the stop loss, which of course is one measure,
however, over a series of trades, this approach will be inadequate. There needs
to be more thought put into risk than most do.Â
First let’s separate this commentary into two distinct camps, HVT and FX.Â
Each will have a very different set of guidelines. Even if you do not trade FX,
the thoughts will translate well to anyone who swing or position trades any
market.
Let’s discuss HVT first since defining risk in HVT is a bit less absolute.Â
First, whenever I get into an HVT trade, I do not have a specific stop loss
point in advance. HVT relies too much on momentum to pick such absolute
technical levels. So, on any given trade my stop loss is usually determined by
whether or not the market is going in my direction. If the momentum begins to
slow and the S&P’s look like they are going to roll over, I am out. Typically
my average stop loss averages around 3-6 cents. If one assumes an account size
of say $30,000, that means you are risking .25% on that trade if you lost .06 on
1,000 shares. This is a very conservative amount to risk on a per trade basis.Â
2000 shares pushed that risk to .50% and so on. The calculation for position
sizing is as follows:
^next^
Position Size:Â (s) = e * r / (p-x)
where:
e = account size
r = maximum risk percentage per trade
p = trade entry price
x = stop loss price
As mentioned above, I need to base my position sizing for HVT on what my
average stop loss is over several hundred trades. In FX I know exactly what my
stop loss is in advance.
So, let’s say that your account has $30,000 in it an you decide you will risk
1% of that account per trade ($300). If you know that over a large number of
trades you average a loss of .06 cents on losing trades, you know that provided
there is adequate liquidity in the stock you trade 5,000 shares of stock. If
you lose .06, you lose only 1% or $300.
Naturally the stock market is not a game of absolutes, stocks gap up and
down, there may be no buyers/sellers when you look to get out etc. But this
gives you a fairly accurate way to determine risk before you even place the
trade.
Now let’s turn the focus to applying it Swing and Position Trades, in these
instances you will typically have a very good idea of what your stop loss is in
advance. In fact you have to if you want to be able to know exactly what size
shares or number of contracts to trade. No trader and or money manager who has
demonstrated consistent performance does not go through this exercise each and
every trade.
Bear in mind, now amount of risk control will prevent a trader from
eventually losing lots of money unless the system they employ is robust. In the
example above, after 100 trades of losing 1% the account would be wiped out.Â
This brings us to the next section which is determining whether or not the
approach/system you use is robust. A good win/loss ratio is a fair measurement,
but do your winners outpace your losers be a good margin, the so-called
R-factor? And what about expectancy, does your series of trade show a positive
expectancy.
I discuss this topic at length because I am going through these same
exercises with my own FX trades. I have sliced and diced the FX trades from my
FX service as a way to get a real good handle of refining even further my
trading approach. To date the system is profitable and effective, however, one
cannot become complacent and always needs to be vigilant of factors that can
cause real pain.
I will resume a more trading oriented focus in tomorrow’s column but I
thought that this might be of interest to everyone.
As always, feel free to send me your comments and questions.
Dave