When I was teaching trading courses at another organization, I was once accused of sounding like a broken record when for each and every class I spent ten to fifteen minutes covering and reviewing money management in the trading game. I took this as a compliment.
Money management in trading is a core skill. If you don’t have it, you won’t make it over the long term. Period. This post is going to cover the most critical element of money management - Risk.
For me risk is defined by the % of drawdown in my account that I can psychologically accept with no stress. I focus on %’s, not $’s. I don’t lose sleep if I am tracking (in real time) a rare seven day bad run with a combined 18% drawdown. However in real $ terms, that drawdown for my personal trading account is over $40,000. I don’t even look at the dollars. And by the way - it is impossible to not have losing trades in this game. We have to deal with it!
That 18% is important - it is my personal threshold of malaise and insomnia. It is also important as it is the end number in my per trade risk tolerance calculation.
The above table represents the probability of consecutive losses vs. a traders win/loss ratio in over 100 trades. If you are a 50% trader, you theoretically have a 37.7% probability, at some point over 100 trades, of achieving 5 losses in a row; If you are a 60% trader, you would have a 7% probability of realizing 7 losses in a row.
I am, on average, a 60% trader.
Having a 7% probability of losing 7 trades in a row and a 2.8% probability of losing 8 trades in a row gives me my position size. 18% drawdown divided by 7 trades is just over 2.5%. As the saying goes: “Shit happens.” I therefore RISK a maximum of 2.5% per trade.
Managing RISK in various asset classes…
Equity Options
If you buy a put or call, a long butterfly, a long calendar, etc…, your risk is the premium you pay. You can never lose more. Period. However, it is also possible to put a stop loss on options that attempt to limit a loss to a given value.
So for example, if I buy QCOM put debit spread for $144 in premium, my real risk is $144, but I can also have a potential risk of $72 if I put a stop loss order to sell if the value of the spread declines by 50%. In this case, to have a [potential] risk of 2.16%, I can buy 3 contracts for a total cost of $432. Note that my broker will deduct $432 from my account.
A majority of the trades presented in this publication to date are iron condors over earnings releases. Risk in an iron condor is based on the difference between the bought and sold call strikes and the bought and sold put strikes—less the net premium received. This last week, I sold one iron condor contract on BBY (as announced in Balancing results through diversification of systems and asset classes...) Max risk was 1.98% of this publications $10,000 account. The trade lost $132.
Risk graphs courtesy of TomsOptionTools
As many readers know, my option trading style primarily focuses on very short term overnight trades with with weekly options. I therefore consider my risk as “all in” and position size with a maximum of 2.5% of my account.
Foreign Exchange
Several years ago, I began discussions with a neighbor who is a forex trader. This was enlightening as he treated risk in a different way than I did for options. Risk is fully based on where your directional prognosis of a currency pair is wrong.
For example, if you believe USD.JPY will see resistance at the 13 eMA (red moving average) on the daily chart, you still need to define where you are wrong to place a stop loss. The above shows a defined stop of 215 pips.
There are some really great free tools to help position size forex trades based on risk. One is Baby Pips.
Selling 13,220 units of USD.JPY at 142.135 with a stop loss at 144.35 results in a risk of $200. Note that Foreign Exchange is traded on margin, with the usual amount being 100 to 1. In this example an account would incur a $132.20 margin hold.
Categorically, I position size with a maximum of 2% of my account for Foreign Exchange trading. I consider this a catastrophic stop and often exit a position well before being stopped out based on a violation of my trading system.
To look deeper on how I position sized, below are links to three Foreign Exchange trades from this week, the first two on NZD.USD Tuesday based on the 15 minute chart and am 1/2 way through one on AUD.USD Friday based on the 4 hour chart.
Conclusion
Position sizing by considering your potential drawdown vs. the probability of consecutive losses based on your personal win/loss ratio is critical for sustainable success in the markets, no matter what asset class you are trading.
While position sizing with 2 to 2.5% of an account seems like a miniscule amount, wins adds up very, very quickly if risk is minimized and profits are taken based on a plan. This quarter has been outstanding for all of my trading (although it is only 2/3rds finished). Account growth is currently at over 68%.
Fall Earnings Season 2022 is wrapping up. Below are the final plays for the season. Also - going forward until through December and January until the next ER season, I’ll be spending more time writing about Foreign Exchange trading, systems, and opportunity identification. Premium readers on my Telegram channel may see an occasional FX alert at the end of the day, based on the daily candles (at around 4:15 to 4:30 Wall Street Time.
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