This blog post was written back in 2006 when I first started trading. I thought there are some key concepts that are useful to new traders.
I have a habit of writing down whatever I learned, this helps me to ‘burn’ the information into my mind. I did this during my school time as well. I decided to jot down what I have read from books so far in the Lecture Note series.
As mentioned in my previous posting, I am following Percent Risk Model for my position sizing. Of course, this is not the only model available, it is just the approach I applied in my trading.
I have amended the approach to suit my style. Basically, I will define the initial stop level base on the chart. It can be a support/resistance level, straight trend line, Count backline, or swing high/low.
RISK – the point at which I will get out of the position in order to preserve my capital. It is x percent of my trading equity, for example, I will risk not more than 2% of trading equity in any trade.
Percent Risk Model – Controlling my position size as a function of the risk. For example, with account size of $50,000, 2% of $50,000 is $1000. That means in any trade, I shall not risk more than $1000 with this account size.
If I got a Long signal for SIMSCI at 289 and I have figured out from the chart, the proper stop loss level is at 287.5. On a one-contract basis, this trade requires a $300 risk. With a maximum risk amount of $1000 available to me, I will be able to buy ($1000/$300=3.33) 3 contracts in this trade.
I quote a portion of Dr. Van Tharp’s explanation from his book
Just how much risk should you accept per position with risk position sizing? Your overall risk using risk position sizing depends upon the size of the stops you’ve set to preserve your capital and the expectancy of the system you are trading.Dr. Van Tharp
Here goes on the explanation:
if you are trading other people’s money, you probably should risk less than 1 percent per position. If you are trading your own money, your risk depends upon your own comfort level. Anything under 3 percent is probably fine, if you are risking over 3 percent, you are a “gun-slinger” and had better understand the risk you are taking for the reward you seek.Dr. Van Tharp
He explained the relationship with system expectancy as well:
if you have high expectancies in your system (i.e your reliability is above 50% and your reward to risk ratio is 3 or better), then you can probably risk a higher percentage of your equity fairly safely.Dr. Van Tharp
The percent risk model is the first model that gives the trader a legitimate way to make sure that a 1-R risk means the same for each item he is trading.
The advantage of this model is, it allows both large and small accounts to grow steadily. It equalizes performance in the portfolio by the actual risk. On the other hand, the disadvantage will have you reject some trades because they are too risky.
These concepts are very important for new traders to understand.