July 8, 2015

Position sizing and risk management

This is the most neglected aspect of trading and the reason why most people lose money on a regular basis. 

In the stock market, everyone wants to know how much money they can make. No one will ever ask how much they can lose. 

If you can predefine your loss, you will automatically learn to control your losses and manage a trade. It does not matter if your trades are wrong. 

Half your trades are anyway bound to fail (statistically speaking) so following this simple rule will automatically limit losses and help you stay in the market. 

Position sizing answers the question: how much quantity should you trade. 

Quantity to buy = (1% of trading capital) / (Purchase Price - Stoploss) 

Eg. Assume an initial trading capital of Rs.100,000/- and a risk per trade of 1% or Rs.1,000/-. You want to buy a stock (or option) trading at Rs.100/- with a stoploss Rs.90. 

The quantity you should buy is 1000/(100-90) = 100 shares. You are investing Rs.10,000/- and if your stoploss gets hit, your maximum loss will be Rs.1.000/-. 

Let's assume your stoploss gets hit.

You are now left with Rs.99,000/- and for the next trade, your loss per trade is Rs.990/-.

In above example, say the stoploss is Rs.95. The quantity you should buy is 990/(100-95) = 180 shares. You are now investing Rs.18,000/- and if your stoploss gets hit, your maximum loss is still Rs.990/-.

The capital for the next trade is 99,000-990=98,010/-. Note that your capital is reducing but the rate of reduction will also reduce. 

It is obvious that this simple exercise will ensure that you still stay in the game and have a good chance of a profitable trade.

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