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adding size while maintaining nominal risk

Discussion in 'Risk Management' started by c.chugani, Aug 20, 2011.

1. c.chugani

Dear all,

Is there a formula or quick rule of thumb that determines how many contracts / shares can one add while maintaining the initial risk per trade (in dollar terms) which was established?

Kindly note that I am refering only to trades that go in the trader's favour - ie. the successive entry prices to add size would be worse than the initial entry price. Hence increasing the average price per share if one is long and viceversa if short.

I reckon the only way is to reduce the stop % - ie. move the stop level higher if one is long (lower in the case of having gone short)?

The problem I find with this approach is that one would have less margin of error each time size was added, thus increasing the probability of being stopped out (ie. not giving the trade "space" to continue in the trader's direction)

2. MGJ

Yes there is.

Here is how you can discover it for yourself. First, calculate your total risk of the position at the time of entry: (\$ risk per share at entry) x (#shares at entry). Let us call this number "TRAE" for TotalRiskAtEntry.

Now, some amount of time after trade entry, calculate your total risk right now: (\$risk per share right now) x (#shares right now). Let us call this number "TRRN" for TotalRiskRightNow.

If the trade has moved in your favor and if your stop has tightened up, there is a chance that TRRN < TRAE. In other words, the risk right now is LESS THAN the risk at entry. If so you can take some additional risk, equal to (TRAE - TRRN).

So use this additional amount of risk, to calculate how many shares you can add onto your existing position, thereby lifting your TotalRiskRightNow, back up to the TotalRiskAtEntry. Express it as a formula and email it to yourself. Post it here if you're feeling generous.

That wasn't so complicated, was it?

3. c.chugani

MGJ, thanks for your post, it wasn't so complicated

It is nice how you have laid it out in order to construct a formula for quick calculation.

However, as you yourself have stated, the only way for TRRN < TRAE is if stop is tighter than initially.

Therefore increasing size at same amount of risk comes at the cost of lowering the stop % (thus increasing the odds of being stopped out - for the stop level is each time closer to the average entry price level)

Is this reasoning correct?

Cheers.

4. J.Joseph

If I understand the equation correctly, I'm not sure I agree with the reasoning. If I enter a stock at \$50 and set a stop at 49 (2%) then I'm risking 2%. If I then add to the position at \$55 and move my stop so that I still have an overall risk of 2%, then I've just created a scenario where I have to be right twice in a row in order to not lose that 2%. I don't like those odds.

As an alternative, I treat each pyramid (increase size) as it's own trade. Let's say I buy 100 shares at \$50 with a stop at \$49. I add more shares at \$55. For this to be a good decision for me I need the first 100 shares to be enough of a win that a 2% loss of the second batch still equals a win of at least 4% (2:1 reward). So, 100 shares bought at \$50 and sold at \$52 is a \$200 gain, or 4%. So when I add to my position at \$55, I can buy 200 additional shares and still mee that criteria if my stop is at \$54. 100 shares gain \$4 each, and 200 shares lose \$1 each for a total gain of \$200, or 4% account growth between the two. In other words, the second trade risks a portion of the first trade's gain while still meeting my risk/reward ratio criteria for my trading plan.

5. c.chugani

Joseph,

I think we are trying to explain the same thing. To follow with your example:

- if you first enter at 50, stop 49, your risk is 2% (50-49/50)

- if you later pyramid at 55, stop 54, your risk for this "second" trade is 1,81%. (55-54/55)

Hence, to maintain your original nominal risk while pyramiding at a higher level, you had to reduce the stop % (from 2% to 1,81%) on the second trade.

There will come a time however - assuming the trade continues to go higher - that in order to maintain your original nominal risk, the stop % required would be so low, that the odds of getting stopped out would be extremely high.

6. J.Joseph

That's fine. If we're saying the same thing I guess I didn't understand right. I though you were saying buy at 50 with stop at 49 for a 2% risk. Pyramid at 55 (with a cost average of 52.5) and set the stop at 52 so that the overall risk is still a loss. That's what I wouldn't do. A little confused I guess.

7. Etr8r

I often see explanations for calculating various market stratagems, and they are easy to follow except for one thing... Risk. Risk is often part of the equation but I've never seen how a value for risk is derived, yet one cannot make the calculation without the value.

Can someone explain how to calculate risk for futures such as the ESx or NQx?

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