Money Management: Risk, Position Size & Stop Loss

Stormin_Norman · 28 February 2008

disarray said:
sorry Trembling Hand, whats an R loss? and when scalping you watch the whole trade so you won't lose more than you are willing to, so i don't understand what you mean when prawn86 is overleveraged. cheers.

I grabbed this from the scalping thread to shove it in its own. Cause position sizing is vital and underutilised.

R = Risk.

Its to standardise things. rather then people talking about different amounts of money, they talk about the 'degree of risk'.

So if my 20 point stop loss was hit and would cost me $200 then 1R= 20 pips or $200 for my trade.

A 1R loss would be the loss of 20 pips/$200 and a 1R gain would be the opposite.

A 3R gain would be a gain of 60 points/$200 etc.

Its to standardise trades, rather then talk about dollar values.

Overleavered

Overleavered comes when you risk too much of your initial capital on a trade.

Will a 20 pip stop loss hit see you lose $20, $200, $500, more?

Conventional wisdom backed up with statistical theory says traders should not wager more then 2% on an individual trade.

Why though?

I wrote this in my blog the other day, so I'll repost it:

Monday, February 25, 2008
The Risk of Risk

I have recently become aware of why only risking 2-5% of total account balance on any one trade is vital. Rather then trying to explain the theories behind having controlled risk on trades I have linked readers with a small excel sheet to show the results graphically. The results show that using a risk ratio which is too high will almost always lead to the account being bankrupted. Download it and run it for yourself.

Matt Bowen over at mptrader.com has written a great little excel sheet the shows why having appropriate risk controls are important. Download it here and have a play with it: http://www.mtptrader.com/MoneyExpert.xls

If the excel sheet seems a bit confusing and you can't figure out how to use it; this video should explain it easily:http://www.mtptrader.com/videos/MoneyExpert.html

After playing with the risk variable it should be noticeable that the rate of account bankruptcy dramatically increases above 5%. At 10% risk exposure per trade it is more likely then not you will blow your account, unless returning a good amount of timely winning trades.

Why is this the case?

Effectively by having a high risk ratio the trader is trading too large a quantity of currency. That effectively is making the trader 'under capitalised' for the position he is taking. The problem with under capitalisation? - it reduces the Trader to that of a gambler and the gambler's ruin problem (http://en.wikipedia.org/wiki/Gambler's_Ruin) whereby the participent in the game with the most money (the market) send the other player (the trader) broke.

From these two observations I have strictly limited myself to exposure of 2% on any given trade.

I check out this website to help you calculate how many lots I should purchase given the currency, account balance and stop loss level http://www.forexcalc.com/ .

I have used this for the basis of my calculations for position size.

Stormin_Norman · 28 February 2008

Ok first question I have.

Is buying a 2% trade on a currency, then buying another 2% as the currency goes on to rally further - cheating?

Personally I believe that it isn't (I want to see if others just think I am justifying my bad risk management).

I see them as two seperate trades, each has its own stop losses and take profit.

I'd like to hear other's opinion of this. Am I cheating??

Trembling Hand · 28 February 2008

As always it depends. If you second entry is a fair way away from your first it is not/shouldn't get you in trouble as long as you still stick with the normal stop for both trades especially the second entry.

Really when you are on a good trade I think you need to really push it. So nothing wrong in giving a really good trade a nudge. Trouble is you gotta know when that 1 in 20 or 1 in 50 trade is that you should push. I think it was Soros that said there is no greater crime than being right and not making money.

Trembling Hand · 28 February 2008

Another trap is thinking two trades aren't the same when they are. For example long AUD v USD and LONG JPY v USD. each trade your stop is 2% but really you have a 4% risk on the USD.

I think CFD stock traders do this all the time. Hold 5 different stocks, mostly miners, with a say 4% stop. The markets has a nasty gap down overnight and all of a sudden all 5 separate holdings are acting like one big stink ball messing up your account.

Stormin_Norman · 28 February 2008

Trembling Hand said:
As always it depends. If you second entry is a fair way away from your first it is not/shouldn't get you in trouble as long as you still stick with the normal stop for both trades especially the second entry.

Really when you are on a good trade I think you need to really push it. So nothing wrong in giving a really good trade a nudge. Trouble is you gotta know when that 1 in 20 or 1 in 50 trade is that you should push. I think it was Soros that said there is no greater crime than being right and not making money.

I hold my trades for more then some people. Sometimes 8+ hours. Sometimes some very visible trading opportunities pop up as support/resistance levels vary the trend.

It seems a shame to me to allow obvious trading opportunities to be passed up. I usually want my trade to be +1R. After it passes just above that I usually push up my stop loss to break even.

Only when my first trade is at a break even stop loss do I go in for a second trade. I figure having a stop loss now at zero means the risk in that trade is now 0%.

I guess this could add onto your second post. When the first trade's risk = 0% I can either buy into the same currency at an opportune time, or one of its crosses and keep my overall risk at 2%.

This is obviously only for trending, fundamentally strong currencies where the trend seems like its going to waste.

Thoughts?

Kauri · 28 February 2008

Trembling Hand said:
Another trap is thinking two trades aren't the same when they are. For example long AUD v USD and LONG JPY v USD. each trade your stop is 2% but really you have a 4% risk on the USD.

I think CFD stock traders do this all the time. Hold 5 different stocks, mostly miners, with a say 4% stop. The markets has a nasty gap down overnight and all of a sudden all 5 separate holdings are acting like one big stink ball messing up your account.

strange as it seems... they don't always move in tandem... in the first 5 months of this chart skip went from 77 to 88... and the yen ploughed a pretty much sideways furrow...
Cheers
..........Kauri

disarray · 28 February 2008

buying a second lot means the first lot is already profitable lowering its risk % to your equity. so by taking the next trade you are taking advantage of a higher than normal probability event while the overall outstanding risk is buffered by profits already in place. so its less 2 seperate trades more one large trade with a risk discount. doesn't seem like cheating, seems like a good idea.

Trembling Hand · 29 February 2008

Kauri said:
strange as it seems... they don't always move in tandem...

Yes fully agree but sometimes they do. That's my point.

yonnie · 28 April 2008

hello folks,

am analysing the forex world and it seems to me that only about 10 pairs have enough liquidity for trading.
half of them have the US dollar in the pair and are more or less correlated.

I would like to trade for the longer term (weeks/months).

having a larger stop loss than in short term trading and taking in account the 2% of capital at risk rule, I cant see how I can invest my capital in forex exclusively.
not enough pairs.

anyone care to comment?

thanks

tayser · 28 April 2008

If you're going to be trading over weeks/months, liquidity (and spread) of the pair will be the least of your worries. You want a pair that ranges consistently rather than a pair with a shizzleload of market depth.

yonnie · 28 April 2008

sorry tayser, I think you misunderstood me if you think my question is about market depth of a pair.

suppose somebody wants to invest 100k......with the 2% rule you would need at least 10 trades going all the time. I doubt you will find 10 pairs to invest in according to my criteria longer-term. if that is so, it would mean that the forex market is not deep enough for the longer-term trader.

tayser · 28 April 2008

^ it's in relation to what you've worded:

yonnie said:
hello folks,

am analysing the forex world and it seems to me that only about 10 pairs have enough liquidity for trading.
half of them have the US dollar in the pair and are more or less correlated.

I would like to trade for the longer term (weeks/months).

anyone care to comment?

thanks

holding trades over the longer term doesn't require liquidity (how much of a currency pair is available at any one time) in the pairs, you want the pair to range (or break out from its ranges!) consistently.

An illiquid currency pair only has a small amount available in its market depth (like AUD/ZAR) - ie. there's only a few hundred thousand / few million available on the best price.

A liquid currency pair has multi-millions available on its best price & and just near the best price available at any given time (EUR/USD, USD/JPY, GBP/USD, AUD/USD etc).

For instance, EUR/AUD isn't exactly the most liquid pair, but it ranges nicely (100s of pips) which no doubt you could exploit.

HTH

Money Management: Risk, Position Size & Stop Loss

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