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Discussion in 'Risk Management' started by Aston01, Feb 20, 2012.

1. ### Aston01

I know this might sound like a stupid question ( I thought it was until I really thought about it), but I often hear people talking about only risk 1-2% of your total account value per trade.

I assume most people think about it the way I did and figured if you have a \$30k account then you should stick with buying \$300 worth of whatever you are trading.

Makes sense I guess, but what about if you set a 5% stop loss on entry ? If that is the case (obviously barring a scenario where your stop was blown past for some reason) aren't you actually risking much less then 5% ...actually more like .05% of \$30k if my math is correct ?

If possible I would appreciate it if someone more knowledgeable could double check my logic on the below.

Assuming I am buying a stock priced @ \$1 and during the time I hold it goes up in value to \$1.50 wouldn't the math on the below be accurate?

Account Balance: \$30k

1% of Total Account w/o Stop
Amount at Risk = \$300
Value @ Exit = \$450
Potential Profit = \$150
Risk:Reward Ratio = 2:1

1% of Total Account w/ 5% Stop
Amount at Risk = \$15
Value @ Exit = \$450
Potential Profit = \$150
Risk:Reward Ratio = 1:10

1% Total Risk using 5% stop
Amount at Risk = \$300
Value @ Exit = \$9000
Potential Profit = \$3000
Risk:Reward Ratio = 1:10

Obviously additional slippage and commissions have to be factored in, but it looks like it makes a big difference depending on your view point so I thought would try and get some opinions.

If you're buying a stock for \$1 with \$300, you're buying 300 shares of that stock. This means that every penny change in the price of that stock is going to cost or benefit you by \$3. If you are limiting yourself to a \$15 stop, your stock can only go against you 5 cents. In other words, if your stock falls to \$0.95, you will be stopped out.

That's probably too tight of a stop, based on my limited experience.

3. ### 1a2b3cppp

Let's say hypothetically your risk on a single trade is 1%, like you said.

So if you have a \$30,000 account, that is \$300.

That means your position size is going to determine how far against you a position can go.

If you buy 300 shares of a stock, that means it can go against you \$1.00 before you hit your \$300 loss.

If you buy 150 shares of a stock, that means it can go against you \$2.00 before you hit your \$300 loss.

If you buy 600 shares of a stock, that means it can go against you \$0.50 before you hit your \$3.00 loss.

The next thing you have to take into consideration is the price of the stock. A \$1.00 change in one stock might represent a 1% movement (if the stock is currently trading at \$100 per share).

A \$1.00 change in another stock might represent a 5% change in price if it is currently trading at \$20 per share. This stock might take a few days to go +/- \$1.00.

A \$1.00 change in another stock might be a 0.33% change if the stock is currently trading at \$300 per share. This stock might move \$1.00 in a few seconds.

So you can't just arbitrarily say "I'm going to buy 300 shares of stock and put my stop loss in at a \$1.00 loss."

One way some people do it is to look at their stock, determine (from looking at the chart) where they want to place their stop, and then from that determine their position size so that, if their stop is hit, it represents the percentage they wanted to risk. This may result in buying different position sizes in different cases depending on what the stock is doing. I can post examples if you want.

4. ### 1a2b3cppp

I just realized your example was on a \$1 stock.

\$1 stocks are basically gambling. Math and risk:reward calculations get thrown out the window because those stocks don't play by the same rules.

5. ### Aston01

I used the example of \$1 per share with a 5% stop meaning a stop at \$.95 . I understand that if it was \$10 per share the stop would have to be at \$9.50 and the number of shares would be fewer .

These are just simple numbers for an example to check my math. My question is is the assumption of 1% risk based on the total amount traded or the total amount risked ?

There is a big difference between the 2 options when you factor in the adjusted risk when using a stop vs not using a stop.

Account Balance: \$30k

1% of Total Account w/o Stop
Actual % Risk = 1%
Amount at Risk = \$300

1% of Total Account w/ 5% Stop
Actual % Risk = .05%
Amount at Risk = \$15

1% Total Risk using 5% stop
Actual % Risk = 1%
Amount at Risk = \$300

6. ### rwk

One-percent risk on a \$30k account means risking 1% of \$30,000 (i.e. \$300). The number of shares you buy will depend on the price of the stock and the distance you are willing to let it run against you before you bail. You should factor in slippage so you don't exceed your risk tolerance in a worst case.

Regarding some of the other comments, I don't usually trade stocks priced under \$3.50, but what I am really looking at is liquidity (i.e. average volume). With lower-priced stocks, commission and slippage are a much bigger issue. It's usually better to play higher priced and fewer shares.

7. ### achilles28

Not sure where you're going with that example.

In real simple terms:

Account at risk = stop size x number of contracts/shares.

1) Pick your account risk per trade (1% of 30K = 300\$)

2) Pick your stop size. This is usually based on based on technicals.

3) Solve for number of contracts/shares.

Example.

300\$ = 5 cent stop (0.05\$) x S (Shares)

300\$ / 0.05 cents = S (Shares)

Shares = 6,000

Another example.

300\$ = 20 cent stop (0.20\$) x S

300\$ / 0.20 = S

Shares = 1,500

Reverse compute.

1,500 shares at a 20 cent loss = 300 dollars = 1% of account value.

8. ### Aston01

Thanks, Achillies

That was the logic I was trying to double check... I see a lot of people saying ... "I have a \$10k account and risk 1% ... so I buy 1x \$100 contract at a time"
which goes to show 1% risk isn't always viewed the same.

I appreciate the other responses, but please don't get hung up on the example price of the stock I used. I was merely trying to keep the numbers stupidly simple.

Amount risked doesn't mean that's all you use to enter a trade. If you are going to only use 1-2% of your capital, what are you going to do with the remaining capital?

Typically when people say risk 1-2% of capital, they are talking about how much loss you are willing to take on that trade before declaring that trade a loser and get out. It doesn't mean you only buy or sell things worth 1-2% of your capital.

10. ### achilles28

No problem. Leverage often gets a bad name.

It's not leverage that matters. But risk per trade.

Also, what some of the other posters said was valid too.

I risk ~2.5% per trade. But that 2.5% is based on an emergency stop.

I often get out with a loss at nearly half that.

Or, in other words, if I set my emergency stop at 12 ticks, I can often get out with less than a 6 tick loss (avg 1.25% risk per trade).

In theory, I could increase my leverage and make a 6 tick loss equal to 2.5% risk per trade, but I don't. I prefer the psychological wiggle room.

#10     Feb 21, 2012
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