Survive in Trading: Position Sizing and Risk Management

Hi, welcome to this video on position sizing and risk management. As usual, before starting, please have a look at the disclaimer. Okay, today I'm going to speak about a very important topic that is risk management. In particular, we will discuss these three terms. Rtd. What are rtd? R refers to the risk per trade. Ok. In other words, every time I decide to buy some shares, how much should I risk? And this is strictly related to the position sizing. Because when we decide the risk per trade, we also know how many shares to buy. The second one, T refers to the total risk of our portfolio and the last one D refers to the maximum drawdown that our portfolio can take. Let's start with the first one. So R is the risk that we take for every trade. And I say that this is a kind of short term survival indicator. Because suppose that every trade you risk, let's say 40% of your capital. In other words, it means that if that trade goes, you don't make money with that, you hit stop loss, you lose 40% of your capital. Well, if you do that after three trades that hit stop loss, you basically are out of the game. And every system that you can trade, you will always have a series of losing trades. You can never have a system that is correct 100% of the times. So it's very important to limit the risk for trade. And this value should be fixed. And I suggest you to take something in the range.05% to 2% of your capital. If you are experienced, you may go to the upper limit around the 2%. Some people may take even three, but I think it's quite high. If you're just starting, I think 0.5% is good enough. And as I said, when we set this risk per trade, this will also determine the number of shares that we have to buy. That is the position sizing. So let's see this with an example. This is the formula. First, the number of shares that we have to buy when we are trading is our capital times the R that we define. The 1%, 2% depends over the entry price minus the stop loss. Let's see this with an example. Okay, here we have a capital of $10,000, right? And we want to risk 1% for every trade. And let's say that the stock we are watching, we want to have an entry price at $15.70 and we put our stop loss at 11.3. I'm not discussing here how to decide the entry price, how to decide the stop loss. This will be the topic of another video for now, let's just say that we know these numbers. Now, how many shares should we buy? Well, if you look at this formula, you have to take your capital $10,000 times 1%. And you divide this by the difference between these two. So what you get is $100 over 4.4. So what does this 4.4 represent? Well, if you enter at 15.7 and your stop loss is 11.3, it means that for every share that you buy, if you hit stop loss, you lose $4.40. So if I want to risk $100, that is the 1% of my capital, how many shares should I buy? You just need to do the ratio, right? So 100 over 4.4, you get 22.73. And since we cannot buy fractions of shares, this is rounded to 22. And if, then you compute how much you are risking, you have 4.4 times 22. And this is 96.8 dollars, right? That is less than your hundred dollars maximum risk. So without considering commissions, the theoretical loss that you have if this trade hits stop loss when you buy 22 shares is 96.$8. Okay, let's move, let's move to the. Sorry. Yeah. Now let's move to the next one. T. What is T? As I say, T is the total risk of your portfolio. And I suggest that you don't take a total risk that is more than 10%. And the reason is this table. This table is showing on the left the loss that you may have and on the right the gain that you need to have in order to break even. And you see here, if you lose 10% of your capital, you need 11.11% to break even. But when you start, sorry, when you start to lose more like 20%, then you see you need 25% to break even. And when this number increase is even worse, when you lose 50%, you need to make hundred percent to break even, right? If you have $10,000 and you lose half, you go back to, you go to 5,000. And to go back to 10,000, you need to make other 5,000. That is 100% of what you have. So when we use 10%, basically we are in a situation where it's still possible not to so hard to go back to the original capital. That's why I think 10% is a good value for the total risk. Let me give you an example. Suppose you have a portfolio with three stocks. And these three stocks are Google Microtechnology and ExxonMobil. It's just an example. And Suppose that when you take your positions you have a risk R of 2%. So Google, you have 2%, MU, you have 2%. And let's say that XOM you have 0%. Why? Because some strategies where you are actually making money, you can raise your stop loss to the entry price. In other words, if the price is coming down and hitting stop loss, you lose nothing. Right? Because your stop loss is now the entry price. So in this situation the risk is now 0%. So in this scenario we have 2% risk for Google 2% risk and MU 0%. So the total risk T is 4%. Now there is something to note here. In addition to this concept of the total risk, we should make sure that we don't take too many stocks from the same sector and industry. And the reason is that stocks in the same sector and industry tend to move together. And to look at the sector and industry we can look@finviz.com that is the website I presented in one of my previous video. Okay. And then we don't want to have stocks that are highly correlated. Highly correlated means they move together. And to look at the correlation, this is the website use. Okay, I will put the link in the description of the video. So just to show you, this is finviz, okay? And I'm looking at Google, you see here, this one is a sector and this one is the industry. So, so when you're looking for sector and industry of a stock, you can use finviz. And this is where you will see those information. And this is the website that I use for the correlation right here on tickers you just need to write the names of your stock. Like in our case we have Google MU and Xom and then we need to put the start and end date. And usually I check three and six months. But it really depends if you are more a long term investor. You may look at the last year for example and when you click here on View correlation you will see this table, okay? And you will see some values. So for each pair like Google mu, you see here we have.049. Now correlation is a value that ranges in like minus one to one. Minus one means that on average when let's say the first stock is going up 1%, the other one is going down 1%. And when you have a correlation of one is the situation where one stock is going up 1% and the other stock the same. And values in the middle are basically, let's say you have a 0.8 correlation. Well, it means that on average when the first stock is going up 1%, the other one is going up.08%. So usually when I have two stocks, right? Suppose you have already googled in your portfolio and you are looking at mutual. If I see in the last three months or six months that I have a correlation very high, let's say above 0.8085, then I avoid to take the stocks because I don't want to be in the situation where one stock is going down and the other one as well. Okay, now let's move to the last one. D. So is the indicator of the maximum drawdown. And this is used to basically assess the volatility of your portfolio. And this is quite different from the previous one because here we are basically checking at the unrealized profit. So first the formula. What do we need to do? For each stock S that you hold in your portfolio, we have to compute this DS that is basically the current price minus the stop loss. And here I use the absolute value because in case you are going short, right? Your stop loss is above the current price. So this value will be negative. So we just take the positive number, the absolute value times the number of shares. And this basically represents your maximum loss, right? Because if the current price is, let's say 10 and your stop loss is 8. Okay, this is 10, this is 8. And you have 10 shares. The maximum drawdown that you can have for this stock is 10-8. So $2 times 10 is $20. When we have computed this for each stock, we need to sum all of them and then we divide this by the current capital. That is also called sometimes NLV net liquid value. And for the same reason that I showed before, I would suggest to limit this value to 10%. So let me show you with an example how to compute this. Suppose we start with this situation. We have a capital of $10,000 and we decide to have a risk per trade of 2%. The R, right? So in this case means 2% $200. Now let's say we have these three stocks, Google. We enter a thousand dollars. We have a stop loss at 960 and we have five shares. And this makes sense because thousand minus 960 is $40, right? Times five is $200. That is our risk per share. So this is correct. And the same year, if you do the computation like here, we are risking $5 for each share and we have 40. So we are risking again $200. And this one XOM. Let's say that the stop loss was 65, right? And now and the entry price was 75. So $10 of risk for each share. And then we bought 20. So 200 again. And with this notation, I mean that now we move the stop loss to entry price. So as you see, the risk is zero. And for the other two, the stop loss is still there. So the risk is 2%. So as before, the total risk is 4. But this is actually telling you that if you hit stop loss for all of them, you will have a drawdown of 4% compared to the initial capital. But what about the drawdown compared to the current capital? Look at this column. Now this is the current price of the three stocks. Google in this example is now trading at 1100 dollars. And this means that I have a DS what we computed before of 700. Why? Because we have a current price of 1100, the stop loss is 960, right? So it means we have 140 dollars of. Maximum drawdown for each share. And we have five shares, so we have 700. In other words, if we hit stop loss, we will lose 700 from the current capital. And using the same formula, you get these three numbers. Okay? Now when we sum up everything, we get 8, 4, 0. What is this number? Okay, to understand this, we need first to compute our current capital. So the net liquid value, we started with 10,000, right? Now look at Google, we enter at thousand. The current price is 1100. So for each share, we have a profit of 100. We have five shares. So this is $500, right? This one, actually we are losing some money because we enter at 60 and now is at 57. So 57 minus 60 times 40. So we are losing $120, right? And this one, XOM, we enter at 75, now is 78 $20, right? So it's three times 20 is plus 60. So if you sum up everything, you find out that our current capital, the net liquid value is 10,440. Okay? This is what we have. Now if we close all the position at the current price, but if we hit stop loss, we are going to lose $840. And this represents something around 8% of the capital. So you see that even though our risk is actually 4%, okay. Compared to the initial capital, the maximum drawdown we can have is 8%. And this is very important because we don't want of course, to have big drawdowns in our capital, right? So in other words, the situation is this. Let's say the price was moving, right? Say you enter here, this is your entry price. And let's say that you put Your stop loss, I don't know. Here, this is your stop loss, right? And this is your R. Now let's say that the price is moving up and now you put your stop loss. Okay? Your stop loss is not here anymore, is here. So it's true. Now this is a risk free trade. Why? Because if the price is going down and hitting your stop loss, you basically you don't lose anything compared to the initial capital. But that's the key. You don't lose anything compared to the initial capital, but compared to the current capital, if this guy is going down, you lose all this, right? So in other words, is important to consider both to consider the risk of our portfolio, but also to consider the maximum drawdown that we can have in our net liquid value. You don't want to have something that is going up, up, up. And maybe you don't move your stop loss because your strategy does not include moving stop loss. And then the price is going up, up, up. And then some bad news happen and all your positions are going down or most of them. And when they go down, you lose a lot of unrealized profit. You need to protect your profit. And if you are exposed too much with unrealized profit, maybe it's better not to take additional position. Okay, so this is just to recap. We have to consider these three things. RTD, what I use in my trades is I risk 1% maximum for each trade. So this is the R, the T, I do not take more than 10% of total risk in my portfolio. And about the D, I limit my maximum drawdown to 8% of my capital. Okay. And of course, as we said, this value is the sum of the risk for our trades and it will change when we move stop loss, for example. Okay, good. So that's all for this video. If you like it, please subscribe to this channel. So when I will upload new videos, you will also have a notification and see you next time.