July 26, 2014

Question on position sizing

Question: Suppose Two stocks have buy signal having price of Rs 100 each. Now one stock has Rs 1 SL, so I hv to buy 1000 shares and second stock has Rs 5 SL, So I hv to buy 200 shares. Am I Right ? But how can I make money management ? because one stock has buy value of Rs. 1 Lakh and second has buy value of Rs 20,000 only ?



It is assumed that risk per trade is 1%.

Now for a predefined loss of Rs.1000/- per trade, the investment amount will vary depending on the actual stoploss for  a trade. If stop loss is small, the quantity one buys and therefore the investment amount will increase. Similarly if the stop loss is large, you will buy a smaller quantity and commit lesser funds.

Nothing wrong with this... this is exactly the way risk management is supposed to work.

Profit maximisation is something else and is an unknown variable in stock markets.

While you can define a loss and thus limit it in any trade, it is impossible to quantify the profits you will earn in a trade. So profits are whatever the markets give and you have no control over it.

But the actual profit should be seen in percentage terms and not in Rupee terms. This means you should look at the profits as a return on investment. for eg.... one trade generated 7% return or another trade generated 15% return. The ROI is what is important and not the original investment amount.

For the given example, if both trades get stoplossed, the total loss will be Rs.2000/-. But if the trade generates a 10% profit, this means an overall return of Rs.12000/-

Any other investment strategy will increase the losses while keeping the profit fixed. 

For eg, if one was to to divide the investment amount equally between 2 stocks is far too risky. To go back to the example if you invest 60K in each stock, the loss will be 600*5+600*1= Rs.3600/-. Note that a 10% return will still mean the same profit of Rs.12000/-.

Obviously position sizing is helping manage the risk without compromising on the profit.

Hope this resolves the dilemma.

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