Saturday, 16 February 2008

The Percent Risk Model

Thinking about Position Sizing

Many think it’s smarter to buy shares in round lots of 100 or 1000 shares. This is not they way you should think when you are trading or investing in stocks. People feel they are getting more for their money when they buy 100 or 1000 shares in round lots. But what difference does the amount of shares have to do with the dollar amount invested. THINK IN TERMS OF DOLLARS. Position sizing should be used to determine how much money you will put in a particular trade or investment. The Percent Risk Model, in my opinion, is the best way to go.

Risk Tolerance=Account Size * Percent Risk of Total Account

$1000 = $100,000 / 1%

Example: If your Percent Risk of Total Account is 1% and your initial account balance is $100,000, then your risk tolerance should be $1,000 ($100,000 * 1%). In effect, you are saying, “I am willing to lose $1,000 on any individual investment.” Anything can happen in the market. So, managing your account in this way will help avoid the disastrous situation of being wiped out. This gives you 100 chances to be wrong before you lose all your money.

Calculating Position Size
You want to figure out how much to place on each trade by assuming a $100,000 account with 1% risk on each position. First, you must determine a stop loss point, in order for you to get out of a trade that is not going your way.

Position Size=Risk Tolerance/Stop Loss Percent

$10,000=$1,000 / 0.10

Example: If your Stop Loss Percent is 10% and your Risk Tolerance is $1,000, then your position size should be $10,000 ($1,000 / 0.10). The $10,000 is then divided by the share price to figure out how many shares you should purchase. The benefit of a position sizing is to manage risk. The great money mangers and top traders spend all their time managing risk!

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