In last week’s lesson, we introduced 2 extremely important measures that all traders need to track and monitor.
Now that we've set that baseline, in this week’s lesson we will build upon the 2 measures we introduced last week and launch into the topic of position sizing.
As it pertains to this month's theme of risk management proper position sizing is key in the practice of risk and loss prevention.
Entire books are dedicated to the topic of position sizing so for the purposes of this lesson I will introduce a very common method for position sizing called Fixed Fractional position sizing.
For those interested in other position sizing methods, here's a brief primer.
In this lesson, we'll discuss -
· What the Reward for Risk ratio is
· How to calculate Risk
· How to calculate Reward
· How to calculate the number of shares to buy in a position using the Fixed Fractional position sizing method
Understanding the Reward for Risk Ratio is important to successful investing and trading.
Most traders are concerned with when to enter a trade, and neglect understanding the appropriate position size and profit potential of the trade.
When considering a trade, it is important to establish a loss limit. You cannot be right on every trade, but limiting losses when you are wrong will improve your long-term performance.
When buying a stock, for instance, plan to sell if it moves below support. When shorting a stock, plan to cover the short when it moves through resistance.
The difference between the entry price and your stop loss price represents the basic risk of the trade.
If you are buying a stock at $10 and will take a loss if it moves to $9, then you have a risk per share of $1. If you don't want to lose more than $500 on the trade, then your position size should be 500 shares (this is a simple example, we should also factor in commissions and slippage).
When looking at the stock's chart, we should also consider what the potential gain on the position is. If we are buying a stock at $10, but the stock will encounter technical resistance at $11, then we only have $1 of upside. If the stop loss point is at $9, then we have the same upside potential as downside potential. That makes the risk reward trade of 1:1.
For most traders, I have found that it is better to have a 2:1 or better reward for risk ratio. That would mean that we would not take the trade at $10 unless we saw good potential for it to move to $12.
You can take trades that have less than a 2:1 reward for risk if the probability of success is very high (70% or better). You can also take low probability trades if the risk-reward ratio is very high.
When you find a good stock chart, you should consider the position size based on the entry price and stop loss point.
Then, consider the likely upside potential of the trade, and calculate the reward for risk ratio. If the trade has a good probability of success, and the profit potential is two times or better than the loss potential, the trade is worth considering. A good chart that does not have enough upside potential to compensate for the downside risk is not worth doing unless there is a very high probability of success.
Good traders are more than good stock pickers, they also practice good risk management, limiting losses when they are wrong and letting profits run when they are right.
Risk is the difference between your entry price and the stop loss price.
The difference between the entry price and the stop loss price is the risk of the trade.
For example, if you are buying a stock at $10 and the stock has support at $9.30 then the stock has $0.70 a share in risk.
Of course, this risk limit requires that you have the discipline and the ability to get out of the trade when the stock comes down to the support price.
The reward of the trade is how much you expect the trade to make. For example, if you are buying a stock at $10 and it has a major level of resistance at $14 then the trade has a $4 reward potential.
There are no guarantees that the stock will get there or stop at that price when it does, but the chart is a way to measure the probable potential of the trade.
A reality that is often hard to accept is that if you are buying a stock that has no resistance then you have no limit to the reward that can be calculated.
For instance, in our current market environment where stocks are giving entry signals as they reach new highs, there is no need to do the risk-reward calculation since there will always be enough reward for the risk.
Here is the calculation to determine position size:
The formula I have shown above assumes that you will be able to exit the stock at our stop loss price. However, because the market can move quickly or gap in price, there are no guarantees that you will be able to get out of the stock at your stop loss price and lock in your risk limit. Do not assume that the maximum loss you will incur is your risk limit.
Also remember that the calculation above was simplified, and did not include commissions. When determining position size, it is important to remember that the commissions you have to pay to enter the position are another factor in the trade.
As I stressed in last week's lesson the important metric of success to follow is the reward for risk that you earn on your trades.
A trader who consistently earns Reward for Risk gains of 2 or less will have to be right often.
A trader who has bigger Reward for Risk winners does not have to be right as often because these big winners can pay for the losers.
Most traders trade reward for risk. That is most traders tend to focus on the entry signal when making a trade but it can be more important to judge the quality of a trade by the potential Reward for Risk.
Long term successful and consistent trading requires the balance between the Reward for Risk potential of a trade as well as the quality of the entry signal.
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