Sunday, May 8, 2011

My new approach to position sizing...

After weeks of deliberation, I have finally settled on an alternative to how I will determine position size on and manage the exits of my swing trade ideas. As opposed to strictly using the percent risk model as I have been using; I have decided to use the percent of equity approach to size my trades. Although the percent risk model is a good one especially for intra-day traders, in my opinion and after years of experience with it, it is not very useful and/or practical for swing traders. This is so for two major reasons.

Firstly,  you can have too much of your account in a single stock. For instance, you might look at a set up and determine that the best stop loss should be about 1% from entry price. If you risk 2% of your account per trade, this means that you can get 200% long this stock. If you do get 200% long this stock and it trades down to your stop loss and you get filled there then all is fine and well; you only lose 2% of your starting account value. However, what is gonna happen if you wake up one morning and find that the stock has been halted or that another stock in the industry reported horrible guidance and your stock is set to gap down 30% i.e. your account will be down a whopping 60%! (If you have been trading for a while you will know that this is very possible!)

The second reason has to do with diversification. Although I believe that too much diversification leads to under performance and unnecessarily high commission costs; some diversification is needed! The reason for this is that you might see about 4 or 5 set ups that you really like that all look capable of making a big move but based on the percent risk model you might only be able to buy 2 or 3 before you are already on full margin. So that although the 2 or 3 you pick might do well you will often find that one of the others that you did not enter out performed dramatically and would have made your year with even just a small exposure to it!

For these two reasons, I have decided from now on that I will allocate either 20% - 25% of my equity to a trade as long the stop loss is less than 10% away from entry and I believe that the stock is capable of moving by at least 20% with in the next few weeks or 40% - 50% of my equity to a trade as long as the stop loss is less than 5% away from entry and I believe that the stock is capable of making at least a 10% move within the next few days. Also I will look to scale in to positions, trade around a core position, pyramid into trades and scale out of trades based on the set up, price action of the stock and its peers, pending news and market conditions. I will expand on these aspects a bit more in the future as these are still really in the developmental stages and I have not practiced a lot of these strategies as yet. As I become better and develop concrete rules then I will write a bit more about them.

I hope you find my ideas useful. Please shares your views on how you determine position size and manage your swing trades with me by leaving a comment!

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