We look at a trade; it’s a good trade.... a beautiful clean sideways pattern just itching to breakout. Our plan is to buy the breakout and ride the trend, trail stopping upwards at every pivot low. Cool. So far so good. We now need to ascertain how many shares we plan to buy. For example, the stop is 20 away from our entry point. Right, do we buy 10 shares (which means we lose 200 if stopped), or do we buy a 100 shares (which means we lose 2000 if stopped), or a 1000 shares (which means we lose 20000 if stopped)? The amount of money lost if stopped is the risk on this trade. Don't let it get past 2% of your equity. Which means, first calculation is: How much capital do I have in my trading account? (trading account only, not the worth of your house and car and jewellery all put together).
Let us say that I have 10 million in my trading account, that means the maximum risk that I can take on any single trade is: 2% of 10 million=20,000. Which is to say that if I enter into a trade, and the trade goes against me, I will lose 20000? So whether you paid 2.5 million for that stock or not, you are not risking 2.5 million, but 20000, as that is where your stop is. Now must it definitely be 2% of the capital.... not necessarily. Can be anywhere between 0.5-2%, but no more than that. So, therefore, first I look at my trading capital at the end of the month. I then assess how much my risk would be the next month. For example, let us say I have 10 million at the end of July. Let us say I take 1% loss in each trade. Therefore for the month of August, I would be risking 10,000 per trade (to reiterate, that means the amount lost if stopped out).
Now I have my ups and downs in August, and landed up in August with an equity of 10.5 million, now my risk in the month of September would be 1% of 10.5 million=10,500 per trade.
So too, if my equity had dropped that month to 9.5 million, then my risk of 1% for the following month would be 9,500 per trade... so on so forth!!
Right, I now know my trading capital, the amount of percentage risk that I am willing to take, and the amount of money risked for the following month at the end of each month..... now how do I calculate share size: Share Size= (% risk * trading capital) divided by (entry-predetermined stop loss). So, therefore, we look at our charts, we get our entry point let us say 200, and our stop loss is at 175. Now presuming our capital is 10million, and our percentage risk per trade is 1%. Therefore, Share Size= (1% of 10 million) divided by (200-175)
= 10,000 divided by 25 = 400. Therefore in the above example we would buy 400 shares with an entry at 200 with a predetermined stop loss at 175. The max we should lose in this trade if stopped would be 10,000. The 2% rule for assessing position sizing is vital, but there is more to be done. Another major part of money management that must be looked into..... just as how crucial having a predetermined stop is and proper share sizing, this part is vital for the survival of our trading account and therefore our survival as traders.
If we were to risk 2% per trade and we get into 20 stocks, a move down would trigger all the 20 stops.... we have put proper stops, great... we have taken small losses, great... and yet, our account is down 40%. If our trading capital was 10 million, well 4 million has vanished into thin air!! This is unacceptable.... and unpardonable as far as the trader is concerned. We therefore have another set of percentages in place so that we are protected from market movements.... now what that percentage is basically comes back to the individual trader and his comfort levels. There are many absolute truths in the world of trading, but no absolute methods, all relative to what our psyche allows us. For example, I believe that a 2% risk is just too much to bear; I am on the other hand comfortable with a risk of 0.5-0.75%.... so there are as many methods as there are traders. Basically tweak to your individual comfort levels. Now what are these percentage rules of max risk?
1. In an intraday position, take no more total risk than 4% in that day. Which means that I would take no more than 4 trades at the same time? Why? Because I am risking 1% per trade, and if I take more than 4 trades, I would be risking more than 4% in that day. Therefore, I enter into a stock with my stop loss at the previous pivot low at a risk of 1%. Then I see a great setup in another stock, same thing as above. Now I see a great trade in yet another stock, I grabbed that as well. Then yet another stock. Now I have 4 trades running simultaneously, and I risking 4% as of now. I then see a great play in one more... But my rules prevent me from taking that 5th trade, however juicy that set up. Now I get a great move in 2 stocks, and that gives me the opportunity to raise my stops in the two to breakeven. Now I can take that fifth stock if it still looks great… if it has already run off, well, nothing can be done about it. Missed money better than lost money!! Also make sure you have your max percent loss in a week after which you wouldn't trade any more, and your max percent loss in a month after which you are no more than a bystander. If I lose 10%, that’s it....I am out for the month. Many put that figure to 6% or 8%.........once again, your comfort levels.
2. In a swing position that may last up to 4-5 days, once again similar rules come into play. I basically take a max risk of 6%.......now why these figures, well, basically no real reason except years of toying around and tweaking it to comfort levels. As said before you will have to do the same. So, here again, a risk of 1% per trade allows me to take 6 swings that week. Every time I am able to raise my stop to break even, I am allowed another trade. Else that's that...
3. In a position trade, that can take up to weeks to months, I tend to take a max risk of 12%, meaning that if you are taking a 1% risk per trade, max number of stocks that can be got into is 12. And then, once you get to breakeven stop in a trade, you are allowed to get into a new position, or add to the previous position. If you are the type that can take on a bigger amount of risk, fine... but total portfolio risk no greater than 20%.Greater than that, think you would be fishing for trouble. So careful on that one.
It is very important that these rules are in place.... very, very important!! The percentages you as the trader will have to work out. But you MUST have a stop, you MUST adhere to them, you MUST have a risk per trade and share size accordingly, and you MUST have a max risk that you are willing to take, after which you are going to pull the plugs. And you MUST have a point where a bad day or month is accepted as it is..... and all trading comes to an end. If you are out on the 15th day of the month, that does not mean that you sleep and watch TV for the rest of the month.... You come to work as in every other day, you paper trade, and you do it till the end of the month. Your first trade would be the first day of next month. Discipline is discipline, and rules are rules..... These are like commandments in the Holy Scriptures of the Trader. Not observing them is sacrilege, a blasphemy. They, once drawn up, MUST be followed at all cost.