Today, I wish to discuss 'risk management' and how important it is for anyone who is investing/trading.
I started out trading with the mentality of asking myself "How much could I win?". This mentality made me hold on to positions even though it was going south. In my mind, I was constantly telling myself that I wouldn't close the position unless it was making at least some profits. If this sounds familiar to you, better read on!
I have shifted my view on this to what I feel is a more appropriate way to view a trade, which is to ask yourself "How much am I willing to lose?". Having a predefined amount that you are willing to let go off in the event the trade goes against you lets you feel in control. Your level of uncertainty when it comes to losses is greatly reduced. To do this, adjust your order quantity so that it allows your potential loss to match your risk appetite.
Lets me give you an example:
This is the chart of Sembcorp Marine S51. Lets assume that you want to short at $1.695 and you calculated a stop loss of $1.81. The next question to ask yourself is, "How many contracts should I short?"
In order to ensure that you have a controlled level of risk, lets assume you are going to risk $200 if the trade does not work out. You should calculate the "distance" or the difference between your entry price and your stop loss.
In this case, it would be $1.81 - $1.695 = $0.115
Therefore, the number of contracts you should short would be = Risk Amount/Distance = $200/$0.115 = 1739
If you shorted 1739 contracts of Sembcorp Marine S51 at $1.695 and placed your stop at $1.81, your estimated potential loss is $200. Doesn't this sound way better than an undefined amount where you base position size on "feel" rather than calculated risk?
I will be posting more articles about risk management soon so stay tuned!
Feel free to leave a comment and I'm happy to listen to any of your suggestions or feedback.
As always, happy trading.
Cheers.
Hi,
ReplyDeleteHow does one get the $200 loss in the first place? I think that amount should be based on 1% of your portfolio size. So that means we have 100 losing trades before our portfolio is wiped out. If our portfolio is 100k, then 1% of that will be $1000. If our portfolio is 50k, then 1% of that will be $500. That represents the max losses allowable for each trade.
So let's say I really have 50k (with allowable losses per trade being $500), then the max i can enter is 4,347 shares, or 4300 shares. Can be smaller than 4,300 shares but not bigger than that.
Well, of course, the 1% rule is up to you to change the percentage :)
Yes, you could apply the 1% rule as well. That also depends on your risk appetite :)
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