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Tuesday, September 12th, 2006

How much to risk on each trade (Risk, part III)

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Great poker players and investors both spend a lot of time puzzling the same question: How much should you bet on each hand, or each stock? Whereas the only concern of the the average individual investor is stock picking.

In the previous two installments of ‘Six weeks to a full trading risk/money management plan’ I looked at how to think about risk appropriately, and then looked at some objectives we need to set. This week I’ll look at how much to risk, or bet, on each trade. 
 
All investors have a risk management method, though most don’t know it. The most common method is to simply divide your account into equal amounts, say four or five stocks, in a bid to achieve diversification.

That’s fine, but what happens when your $30,000 account falls to $20,000? There’s a temptation to ‘double up’, or to ramp up the size of bets in each stock, in an attempt to quickly get back to break even. We can look to gambling to see why that’s not the best path to take.

TWO GAMBLING STRATEGIES

There are two main types of money management strategies for gambling, martingale and anti-martingale. A martingale system increases bet size as you lose. It is supposedly derived from a London casino operator in the late 1700s, Henry Martindale (the d has been changed to g over time), who would implore gamblers losing to ‘double up’. But that strategy falls apart when you’re hit by long losing streaks, which are inevitable for most investing systems at some stage, as the investor’s account is likely to decline so severely it can’t recover.
 
Anti-martingale betting systems focus on increasing bet size, or risk, when winning. Under this strategy, the amount gambled or risked falls as your account declines. That prevents a massive account decline. By contrast your account will grow exponentially on a winning streak.

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So it’s best to avoid martingale risk management strategies, which is what most investors unwittingly do by employing the ‘fixed bet’ system. Most people with a $100,000 account will always bet, say, $10,000 on each stock. But if the account falls to $80,000 and you’re still betting $10,000 per trade, you’re actually increasing risk.

There is a way to allocate a suitable amount to each stock that incorporates the anti-martingale system. You risk a ‘fixed fraction’, or fixed percentage, of your account per stock. Under this strategy when the account grows, you risk more, and when it falls, you risk less.

SOME SIMPLE MATH 

Using the fixed fraction, or fixed percentage, method to work out how much to invest in each stock requires a bit of math but is fairly basic.

Say you wanted to risk 2 per cent of your $100,000 account: that means you could lose $2,000 on the one position. So how many shares of a $1 stock could you buy? Let’s assume that your stop-loss level is 95c. That is, if the stock falls below 95c, you will sell no matter what. Simply divide the $2,000 by how much you are prepared to risk for each stock, or the 5c. So you could buy 40,000 shares with a stop at 95c and only risk $2,000, or 2 per cent of the account.
 
If the account increases from $100,000 to $150,000 you still risk 2 per cent of your capital, but that is now $3,000. So as the account increases your bet rises, so the strategy is anti-martingale. Similarly if the account falls to $50,000, you still bet 2 per cent, but now it’s only $1,000.
 
For those buy and hold investors who don’t use stops, you can assume that you’re risking the entire value of the share, which will dramatically reduce the amount allocated for a stock. For the above example, assuming the whole of the 100c is risked on the stock, with a $100,000 account, and risking 2 per cent, or $2,000, you would only be able to buy 2,000 shares.

Those who want to be particularly aggressive should not risk more than 5 per cent per position. Risking more on each stock should increase returns, but will also cause more volatility in the account. But there is a point, usually risking more than 5 per cent of your account, where increasing risk actually causes returns to start falling. That’s because the account suffers declines that are so steep that the capital needed to bounce back isn’t available.

Next week I’ll look at some simple strategies to determine the optimal proportion of your total portfolio to risk.

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Word Count: 732. This entry was posted on Tuesday, September 12th, 2006 at 8:05 am and is filed under Risk management. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.