Monday, September 27, 2010

Position Sizing X STOPs

I think one of the most important and still most overlooked aspects of trading is risk management.

If you don't have a system to control your risk you can be sure of one thing: you're on the right track to blow your account up (or "optionblast", like we jokingly say on Stocktwits' stream). Trust me on that one, I did blow my account many times before I understood it is a MUST to have a risk control system, at least a simple one as the one I describe here.

Below I explain how I use risk management in my trades on ES (I give ES as an example but it can be used in any market, you just have to do the math).

Before entering a new trade, once I know the area where I'll pull the trigger based on my edge, the first thing I check is where I'll have my STOP in case the trade does not work the way I expect, if the STOP is say 10 points away from my entry point, then this trade is not for me and I will pass it and wait for a better setup, the maximum loss my risk management rules will allow me to have is 3%  of my entire trading account (many people would feel more comfortable with 1 or 2% loss only).

Read this phrase carefully: you gotta love taking small losses, because if you keep the max loss to 3%, you would have to be wrong more than 30 times in a row to blow your account, by using that simple rule you will be able to live for another day, let's see an example:

Let's say your account size is US$ 20,000, the maximum you may lose is US$ 600 in a single trade, so if you have a setup that allows you to have a 3 point STOP, you may play with 4 cars for instance. You have to adapt your limits to the setups that are presented to you, not the other way round, like for example, playing with 8 cars and placing the STOP at 1.5 points, you might easily get stopped out.

And yes! Sometimes you will be stopped out and market will go in your favor, even when the stop is at the "correct" level, it kills you psychologically, but you will be happy that you used the STOP once you go through a fierce movement against you that would have wiped your account out if without a STOP...

Again, the STOP should not be based on a dollar amount but rather in a technical breach, meaning your trade might not work as expected, on the other hand, risk management will take care of the dollar amount to protect you.

This is a basic lesson on how you may determine the size you're going to trade, there's much more you can learn on this topic, but by using this simple system already keeps you protected from a catastrophy.

All you got to do now is objectively identify your edge and control your risk, good luck!

In the book below the author has great ideas about position sizing, I think it is worth reading it, enjoy:

Trade Your Way to Financial Freedom by Van Tharp

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