How Much Should You Risk On A Particular Trade?
As I
write this around 3pm Eastern, the market is pulling back a little
bit today. Volume does not appear to be too high, though. A small pullback is
certainly overdue. Traders who follow the VIX will note it has been nearly a
month since it closed above it’s 10-day moving average. A little selloff at
this point is not a terrible thing. Over the last couple of weeks price and
volume action has improved somewhat. The Nasdaq and S&P have both put in a
couple of accumulation days, and for now the trend remains grudgingly upwards.
The long side has obviously been the place to be, but risks remain high and
upside conviction remains relatively low. It would be prudent to continue to
play things close to the vest and not get overextended. This little run still
looks like it has the ability to crap out at any time.
One topic I sometimes get
questions about is risk. Specifically, how much should one put at risk on a
particular trade? While the number may vary slightly, I believe a good
approximation is the lesser of 2% (of your portfolio) or the amount your
comfortable with. The 2% number is ballpark. This could vary slightly based on
a trader’s style of trading, the risk/reward ratio trades, winning percentages,
etc. The amount someone comfortable with is the more important number. In most
cases the amount people are comfortable losing on one trade is significantly
less than 2% of their portfolio. Many times it may be 1% or less.
That’s fine. The amount
someone should risk per trade should be based more on their risk tolerance and
expertise in trading a particular strategy than on the size of their account.
Someone with a $50,000 account
may feel comfortable risking $1,000 per trade while someone with a $500,000
account may get more upset over a $1,000 loss. Your comfort level is largely a
factor of confidence in trading your particular strategy. Until you are
confident that the strategy will work for you and that losses are only
temporary, any loss — no mater how small – could potentially be upsetting. It
is therefore important for new traders, or experienced traders trading new
strategies, to start off by risking an amount that won’t upset them if lost.
The problem with being upset by losses is that the anxiety created will
oftentimes force traders to alter the strategy. They many times will sell too
early because they’re afraid of losing. Therefore they may not be giving the
trade a chance to work, or they may be taking quick profits instead of letting
them run. These kind of adjustments, brought about by fear of losing, can turn
a winning strategy into a losing strategy very quickly. The fear of losing
self-perpetuates and actually causes the trader to lose money.
If the amount one risks
initially is an amount that they are comfortable losing should the trade go
against them, then they will no longer be afraid of losing on that trade. It
will therefore be easier to manage the trade properly. Once they are able to
build up some profits using their particular methodology, they can then increase
the amount risked per trade. Nothing builds confidence like profits.
.
To do this it sometimes helps
to start slow and build towards goals. For instance if someone is only
comfortable risking $100 per trade, but feel that they would be better off
risking $500 per trade, they should start at $100 and build up. Once there is a
few thousand dollars in profits they can then increase the risk to $200, then
$300, until it’s up to $500. Should a drawdown be experienced along the way and
the profits fall below the level initially set to go from say $200 to $300, then
that would require moving the amount risked back down temporarily. Two-hundred
dollars should be risked again until the profits are back above the original
$300 benchmark.
By doing this traders can
accomplish a number of things:
1)
They can trade a new strategy without
fear of losing, increasing the odds that they will be able to execute the trades
as planned and that the method will be profitable for them.
2)
They can tightly control their risk
without worrying that they are not being aggressive enough.
3)
They can systematically increase the
amount they risk (and hopefully make) as their comfort level (and account size)
grows.
Best of luck with your trading,
Rob