Money Management for Stocks?

[pirx]

Hello!

I'd just like to ask, which type of money management do you people use for stock investing. Is it A) a fixed percentage of your equity, or is it B) you divide your money into x equal units and then risk a percentage of that?

Example A:
2% risk per investment with a 7% stop-loss:
Trade 1: Cash: $10.000; Risk: 2%; Risk ($): 200; Stop-Loss: 7%; Position Size: $2857;
Trade 2: Cash: $7.143; Risk: 2%; Risk ($): 142; Stop-Loss: 7%; Position Size: $2.040;
Trade 3: Cash: $5.103; Risk: 2%; Risk ($): 102; Stop:Loss: 7%; Position Size: $1.458;
etc.

Example B:
$10.000 : 4 units = $2.500/investment. A 7% from that is $175 or 1,75% from $10.000. If I decide to invest all 4 "units" and risk 7% on every investment, my total portfolio risk would be 7%.

I don't understand, why is Example A so widely used. If for example my first investment ($2.857) goes bad, I loose only 7%. But if my third investment turns out to be a winner, my basis of $1.458 is much smaller, than that from my first investment. Why wouldn't be better just to divide my cash into equal units (Example B) and to have the same exposure on all my investments?

Please correct me if I'm calculating this all wrong, but the 2% per investment doesn't make any sense to me.

 

[tomorton]

I don't know that Example A is the more widely used. Its hard to think why a trader would be driven to always use the maximum cash available on every single position. The ones I have known / know of plus myself assess the opportunity, let it decide how much capital to stake, then work out the risk. Bearing in mind that the capital you put into a trade is not just the starting point for determining risk, it is also a commitment to a desired profit within an acceptable timeframe: why would I want to tie up the lion's share of my $10,000 on some slow-moving mega-stock, just because it is first on my trade list?

 

[pirx]

But how to determine, when to risk how much? I'm not a trader and I don't use Risk/Rewards, R multiples, Expectanties and such. So the "2% risk per trade" articles basically say that you should risk 2% from your "risk" equity, and not from your total equity?

I guess I'll just divide my cash into equal units and risk a percentage of that. Isn't this a quite common thing to do?

 

[pirx]

As an example, let’s say that you’ve chosen a percentage risk of 2% of your cash float. If your cash float is $5000, this means that you’d want to risk 2% of $5000 per trade, which is $100. So with every trade, the maximum you’d lose (assuming no gapping or slippage) would be $100. (s.34)

On the other hand, if the risk chosen was 4%, then it would take 25 rather than 50 losing trades in a row to lose the entire float. So as you can see, the number of losing trades required to lose the float decreases as you increase the percentage risk.

This is why I assumed that the 2% is applied to the whole trading equity.

 

[pirx]

Forex Money Management Calculator

This is for Forex. Does Your Equity mean my whole trading account or just the amount I wish to risk for a trade?

 

[tomorton]

The authoritative source of the 2% rule is Alex Elder in 'Come into my trading room'. He recommends a loss no greater per trade than 2% of the total capital employed in trading, not the capital in the trade. He acknowledges that many professionals find 2% too deep and that it would be good practice to actually risk less than that.

Actually, repeated 2% losses will never wipe out the account, no matter how many you take, but they will eventually reduce it to a level from which there is no realistic strategy for recovery.

The location for stop-losses should really be based on TA, the use of a % trailing stop-loss is crude (though I do it) and liable to unwarranted hits. The depth of a TA-based stop-loss can actually be minute, just enough to demonstrate that your entry-point or picture of what the price was going to do next, was wrong. In practice, it should not cost anything like 7% of your entry price to tell you you were wrong.

Of course, you need to allow for spreads, tax, whatever overheads your trading method involves. If trading over short time periods this militates towards very liquid instruments trading at high volume market times, with exemption from tax wherever possible. Clearly, a UK small-cap share with a 20% bid-offer spread and big broker's commission and 0.5% stamp duty is going to be an unlikely candidate.

 

[pirx]

tomorton, thank you for the explanation. Because my stock investing account is somewhat below $20.000, I will divide it to 5 equal units and risk about 7% from each unit. I won't risk more, even if TA would suggest so, because I have no (psychological) problem entering again at a higher price.

As for Forex - if I understand it right, the first (A) example is a common money management strategy. Let's say you start with $10.000 and you risk 2% of that for EUR/USD. You are left with $9.800, and you want to buy AUD/USD. Now you calculate 2% from $9.800 for the second investment. But, if I decide to scale in to EUR/USD again, I would need to risk a smaller percentage than 2%, because correct scaling in should be done with each investment being smaller than the previous.

I'd be very thankful if you could share your view on this.

 

[tomorton]

hi pirx - you are welcome. I still find a 7% stop-loss on a trade a big bite to swallow, even if it is within the 2% rule e.g. I swing trade the FTSE100: holding periods are 2-10 days so you'd think I would accept a wide stop-loss? In fact experience and back-testing have showed me that a trailing 1.5% stop will keep me in past most 'noise' volatility but get me out in profit after a good upleg or downleg comes to an unexpected reversal. Even then I have a rule to never allow my full position to hit the stop, I always attempt to cut it back before we hit the wall - its like braking your car as you see that brick wall coming: you might still hit it, but you won't get hurt so badly. and if you find you can then steer round it, that's OK, you just lost a bit of time on your journey that's all

On scaling in - yes, when scaling in, the final amount you end up risking should not add up to more than 2% of your trading capital. After all, you might pyramid 10 times on a position on XYZ but in reality its one trade on XYZ.

But scaling in is disputed by a lot of good traders as being counter-profitable by reducing exposure and increasing overheads and screen time. They do say that you should go in with your full whack, then start scaling out, could be almost immediately. Maybe in reality it depends on your trading style and timeframes and the instrument you trade but point is scaling in is not an absolute rule.

 

[tomorton]

hi pirx - This 7% stop business is till worrying me. I am sure you know the market you are trading, but 7% seems wide for a trader (though nothing to worry about for a long-term buy-and-hold investor obviously). You know I use 1.5% when I can't position a TA stop less than that on the FTSE100. As a further example, see an old classic - Encyclopedia of Chart Patterns by Thomas Bulkowski.

Decided to refresh my memory of this this morning and on the very first pattern he describes he gives a sample trade based on a broadening bottom or megaphone. The pattern is not key but the point is in the trade he identifies a high at 14 1/8 as a sell signal (this was in the days when US stocks were quoted in fractions) and suggests a sell order at 13 7/8 . He suggests a stop at 14 1/4: this is only 1/8 above the signal (1 tick only I assume), and 3/8 above entry: in percentage terms this is just 2.7%. Its wider than I like on a short-term trade but does this look viable in the markets you trade?

 

[Rhody Trader]

I'm not entirely sure I follow you first post, but when I trade stocks I think about how much aggregate risk I am willing to take and then divide that among the number of positions I'm willing to have open. So if I'm looking to have a 5% aggregate risk - meaning that if all my positions went against me at the same time I would lose 5% of my total account value - and five active trades on at once, then I would size each one to be a 1% risk (assuming equal exposure for each).

 

[pirx]

Its wider than I like on a short-term trade but does this look viable in the markets you trade?

Hi, tomorton. I don't really trade stocks, I hold them for 3 months on average. I invest only in stocks that are at or above $80 and are reaching new 52wk highs. There has to be a nice trend too. Something like MON or MOS, for example.

I never used to scale in and scale out of positions, but if I'm going to trade Forex, I guess I'll have to do this. I plan to trade only 1 pair (EUR/USD). If, for example, I buy EUR/USD at 1.4500 and the price moves strongly by 50 pips to 1.4550, then I might want to add another position. As I understand, the second position must always be smaller, than the first one. If my first position was 2% of my base capital (capital, that is not invested), then the second positions should only be 1% of my base capital. Is that correct?

 

[pirx]

I'm not entirely sure I follow you first post, but when I trade stocks I think about how much aggregate risk I am willing to take and then divide that among the number of positions I'm willing to have open. So if I'm looking to have a 5% aggregate risk - meaning that if all my positions went against me at the same time I would lose 5% of my total account value - and five active trades on at once, then I would size each one to be a 1% risk (assuming equal exposure for each).

That is exactly what I'm going to do, as described in Example B. But as I have calculated, I can apply 7% risk on each of my four $2.500 investments to reach a 7% aggregate risk on the starting $10.000. Did I miscalculated something?

 

[tomorton]

Hi, tomorton. I don't really trade stocks, I hold them for 3 months on average. I invest only in stocks that are at or above $80 and are reaching new 52wk highs. There has to be a nice trend too. Something like MON or MOS, for example.

I never used to scale in and scale out of positions, but if I'm going to trade Forex, I guess I'll have to do this. I plan to trade only 1 pair (EUR/USD). If, for example, I buy EUR/USD at 1.4500 and the price moves strongly by 50 pips to 1.4550, then I might want to add another position. As I understand, the second position must always be smaller, than the first one. If my first position was 2% of my base capital (capital, that is not invested), then the second positions should only be 1% of my base capital. Is that correct?

No it is not completely correct.
I think you are creating a trap for yourself if you can't readily evaluate the risk you are taking on.
e.g.
Monday - Start with 10,000 capital and plan to invest 2000 long in XYZ with intention to scale in / pyramid as much as possible.
2% rule says max risk is 10000 x 0.02 = 200 max
7% stop limit means max drawdown on this position is 2000 x 0.07 = 140. This complies with 2% rule.
Tuesday - You wish to scale in as much additional capital as possible in XYZ. Q - How much can you add?
A - To comply with 2% rule you can add risk equivalent to 200 - 140 = 60.
So, if 60 is equivalent to another 7% drawdown, you can add (100 / 7) x 60 = 857.
Your aggregated position will be 2000 + 857 = 2857. Your max drawdown if stops are hit will be 2857 x 0.07 = 200, which still complies with the 2% rule.

So, yes, your second position in the same market must be smaller than the first - but it is not half the size, in this example it must be significantly less than half the size.

I don't apologise if I have made any calculation errors here - that would only demonstrate my point re the dangers of building a complex trading system.

I don't see all this is getting your nearer profitable trading, but can you make it work?

 

[pirx]

Thanks! This makes sense now. I've read a few articles about scaling in and scaling out, but none showed any mathematical examples. This helps.

 

[tomorton]

That's the theory, now let's make some money! Good luck!

 

[Rhody Trader]

I don't really trade stocks, I hold them for 3 months on average. I invest only in stocks that are at or above $80 and are reaching new 52wk highs. There has to be a nice trend too. Something like MON or MOS, for example.

What makes you call what you're doing "investing" and not "trading"? Just curious.

 

[pirx]

I'm not in for the quick profits.

 

[Rhody Trader]

I'm not in for the quick profits.

Not for nothing, but most of the experienced traders here would say exactly the same thing. That hardly differentiates trading from investing.

 

[pirx]

Not for nothing, but most of the experienced traders here would say exactly the same thing. That hardly differentiates trading from investing.

Well, I also buy a smaller amount of stocks from companies, which I like, but currently they are experiencing troubles. My last such investment was made in TMTA (Transmeta). I don't have any stop loss set, because even if I loose all the money invested, I won't be heavily financially damaged. Not that I don't care, but I will survive it.

Otherwise I choose stocks that are above $80, are reaching new 52wk highs and they trend nicely. I hold such stocks for a few months only.