03/12/2020
Calculating Position Size based on Risk and Stop Loss
Calculating position size and setting a stop loss is key to managing risk within your trades and protecting your hard earned profits. Some traders will use a one-size fits all position size as a percentage of portfolio. I prefer to vary the position size based on where I'm setting the stop loss. The stop loss that I set is based either on the volatility of the stock or on a technical analysis of the chart. I use the average true range of the stock
I represent position size as a multiple of risk (referred to as R). R is the amount of my portfolio I'm willing to risk on a trade. I also like to calculate my profit and losses as a multiple of R.
I can summarize a trade as I risked R with a position size of R10 to earn a profit of R2.5.
I can also summarize a series of trades as I made 10 trades in which 4 trades were successful and 6 trades failed (40% success rate). My average winning trade was R2.5, losing trade is R1. I had total profits of R10 and total losses of R6 for a net profit of R4 and my average profit per trade is R0.4.
If I have $5000 and want to earn $1200 with this system, and never risk more than 1% ($50) per trade, then I'd need ~60 trades. With ~5 trades per month, you are earning a 24% return in a year. Add some compounding too and its more like 27%. Not bad!
In the highly recommended book "Trade Your Way to Financial Freedom", Van K Throp refers to these numbers in the following way:
Expectancy: R0.4 (average profit per trade)
Opportunity: 5 (number of trades)
Expectunity: R2 per month (Expectancy x Opportunity)
Want more profits? You can increase the number of trades (opportunity), improve the success rate of your trades (expectancy) or increase the amount of R (more risk).
On the losing side, if you are losing R2 on each failed trade with 60% failed trades, your expectancy is now a loss of R0.5 and your net losses will be $600 in a year.
That's why position size and risk management is so important. Control your losses, or your profits are for nothing!
Here is how I think about (1) Risk, (2) Stop Loss and (3) Position Size:
(1) Risk
The first step with every trade should be where to enter a position and how confident I am in the trade. I determine a buy point and ask myself how much I am willing to risk on that trade.
For this Idea, let's assume a buy point of the last high in a volatility contraction pattern for AAPL . That would be the high on 11/9 of 121.99. It's already past the buy point, but typically try to enter within 3-5%. Also, I usually add 10-20 cents to make sure the breakout clears the buy point. (Read another great book called "Trade Like a Stock Market Wizard" by Mark Minervini for an explanation of the volatility contraction pattern)
Buy Point: 121.99
Typically, investors will risk 1-2% of their portfolio value on a trade. If you think a trade has more likelihood to fail, then maybe reduce that amount to 0.25% - 0.50%.
For the purposes of this Idea, let's assume we will risk 1% of a $5,000 portfolio. We call this value R for Risk.
R: $5,000 x 0. 01 = $50
(2) Stop Loss
Next I decide where I would set my stop loss for the trade. Many traders will set a fixed stop loss at 7-8% under the buy point. I find this creates too many oops outs (a stop hits intraday and then price rebounds). I use two different methods:
a) I will often use a stop loss based on the Average True Range (ATR) over 10 days and multiplied by a factor (x2.7). I've backtested different factors and found 2.7 to work well. On the AAPL chart the 10d ATR is 2.62. This is a pretty tight ATR and supports the idea that this is a volatility contraction.
Stop Gap: 2.62 x 2.7 = 7.08
Stop Loss: 121.99 - 7.08 = 114.92
Stop Loss %: (7.08/121.99) = 5.80%
b) I will also look at the chart for a technical stop that would indicate that the trade was failing. For example, on the AAPL chart, I would consider a move below the low of 11/24 at 112.59 to be a failure.
Alternate
Stop Gap: 121.99 - 112.59 = 9.4
Stop Loss: 112.59
Stop Loss %: (9.4/121.99) = 7.70%
(3) Position Size
Now that we have the buy point, risk (R) and stop loss, we can compute the proper position size. An easy way to do that is to take the Risk (R) and divide it by the Stop Gap to get the number of shares to buy.
Position Size (Shares): 50 / 7.08 = 7
Position Size (Dollars): 7 * 121.99 = $853.93
Position Size: 853.93 / 50 = R17.07
Another easy way to compute the Position Size is to compute the quotient of 1 and the Stop %.
Position Size: 1 / 0.0770 = R12.99
Of course, the second example, using the alternate and larger stop %, requires a smaller position size to manage the risk to $50.
I use TradingView and/or an Excel spreadsheet to calculate all this for me, but the R notation really helps me conceptualize how big the position will be.
