Capital Management – Risk Sizing
Here are the four steps we have outlined previously regarding Capital Management. Below we will cover the first one in more detail.
- Determine your risk sizing
- Identify your stop price or where you will exit if the trade goes against you
- Calculate your position size
- Examine the risk/reward profile of the trade before entering
Capital management is a crucial element of any trading plan – you will not be successful without it and any minor successes that you happen to luck into will be exactly that, luck.
Time and time again I have heard of novice (and even some seasoned) traders who have lost significant amounts of their trading capital because they have risked too much on one trade or endured a series of account-busting losing trades.
I refer to this as ‘flaming out’ – i.e. failing conspicuously.
The trader who loses too much of their capital on a few trades will not be around long enough to ride the winners – whether that be due to fiscal or mental reasons.
Traders must understand that they will definitely have winners and they will definitely have losers: capital management is all about making the losing trades as small as possible and having a robust structure to ensure you can continue to trade.
Determining your risk size lays the foundation for your entire capital management process and I was taught to frame it as a function of loss. The question to ask yourself is ‘how much of a drawdown in my account would I be able to tolerate before either exiting the market or becoming so dismayed/enraged that it would compromise my trading?’
Be careful how you answer this question. As mentioned in a previous article, I’ve seen plenty of people claim that they could tolerate a 50% drawdown in their account, only to bail once the drawdown was 10%. And fair enough. It’s your hard-earned money that you have built up over time. If 10% is your number, then that’s OK. Be honest. Be realistic. Don’t be a hero. It will cost you money.
Let’s say the number is 10% and the person’s account size is $100,000. They are out of the market and/or their decision making is compromised if the account hits $90,0000. Obviously they are not going to risk $20,000 on one trade because there is a chance that after just that one trade, they will be out of the game. That’s inviting a bad outcome.
Risk per trade for this person needs to be kept small.
Now assume five losing trades in a row. It can happen, it does happen. My longest string of losers over the last 10 years was eight in a row (my longest winning streak was 14). Let’s stick with five. This person has given themselves $10k of drawdown wiggle-room.
$10K divided by five losing trades = $2K per trade.
That’s how much this person should be risking (i.e. be prepared to lose) per trade. That is, if they buy XYX at $10 and it goes down and hits their stop-loss at $X, then their account would go from $100,000 to $98,000.
Their risk per trade is 2% of their overall account ($2K of $100K = 2%).
I hope that is pretty simple to follow. Plugin your account size, the max drawdown you are willing to tolerate and factor in five losing trades in a row, and you should be able to determine your risk sizing or risk per trade as a percentage of your account size.
Please note, the risk size is not the same as the position size. Position size is the size of your overall position in a single stock, and the risk size is how much you stand to lose on that position if the trade goes against you and hits your stop-loss. For example, your position size in stock XYZ might be $10,000 but the risk size, given where you have placed your stop-loss, will only be $2,000. This will become clearer as we move through the other steps but I want to try and avoid any confusion now.
Finally, I have helped many traders over the years construct trading plans and build capital management models and I also know many successful traders around Australia. I have never seen anyone risk more than 5% per trade. The typical range is 2-5%. The other thing successful traders don’t do is play favourite with stocks. Every single trade has the same risk amount. They don’t fall in love with a piece of analysis or a technical setup and decide that they will blow out their risk amount. Always the same.
Remember, a string of five losing trades at 5% of the account per trade equals a 25% drawdown. Most in the market aren’t able to tolerate those kinds of losses without it seriously affecting their ability to stay objective and take the next trade… no matter how robust their trading plan is.