Of all the aspects of stock trading, one of the most difficult
is deciding what size position to open. Unless you are using a
strictly mechanical system that explicitly defines your trade
size, figuring out exactly how much of your hard earned cash to
'put on the line' can be extremely hard to decide. Rules of
thumb such as 'never risk more than 5% of your portfolio' are
fine, but may leave you in the dust on fast moving days. As we
here at www.traders101.com
would say, faint heart never won fair lady, yet look before you
leap! Oftentimes, what looks like an average trade starts to run
away as the stock market climbs, and you end up wishing that you
had taken a large position. And conversely, if you get it wrong,
you can end up banging your head against your computer screen
and wishing forlornly that you had been a little more 'prudent'
in your trading size. Not to worry. There is, in fact, a fairly
simple formula you can use to determine the correct position
size for your stock trades, as long as you are looking for long
term growth. Known as the 'Kelly Formula', this is a useful
little equation that is simple to understand, and simpler to
apply. You will need to have done some trades before, and have
the stats at hand (the ratio of your winners to losers, and the
size of those winners and losers). Lets say that 'WP' means
'Winning Percentage' and 'WL' means 'Historical Average Win Size
divided by Historical Average Loss Size'. The 'Kelly Formula' is
then:- Kelly Forumula = ((WP * WL) - (1 - WP)) / WL Ouch! Scary
maths! Not! To understand this formula, let's take an example,
based on a series of 15 trades. Lets say that you made money on
10 of these trades, at an average of $200 profit per trade, and
lost money on 5 at $100 per trade (you cut your losses! Good
man!). Substituting the figures into the formula, we have:- An
average win size of $200, an average loss size of $100, so the
'WL' number is 2. The Winning Percentage (or 'WP') is 10 / 15 or
0.67 Kelly = ((0.67 * 2) - (1 - 0.67)) / 2 The result is 0.505.
In other words, if your win / loss ratio is consistent, you will
maximize your returns by only risking about 50% of your equity
on each trade. Now the problem you can see is that risking
anything above 5% or 10% of your equity on a single trade would
be regarded by most traders (and certainly everyone at www.traders101.com) as insanely
brave. So the next step is to ask yourself 'What is the absolute
maximum I would be happy losing on a single trade'? You then
multiply this absolute maximum drawdown by the Kelly number and
voila - your position size. If your maximum acceptable drawdown
while stock trading is (e.g.) $1000, then your optimum position
size would be 1,000 * 0.505 = $505. What about if your winners
were only good for an average of $100, whereas your losers ate
up an average of $120? Let's have a look. The 'WL' number is
100/120 = 0.83. The 'WP' or winning percentage is still 0.67.
The substitution then gives you:- Kelly = ((0.67 * 0.83) - (1 -
0.67)) / 0.83 which is 0.274 or about 27.5%. Multiplied by your
'maximum acceptable drawdown' of $1000 this is $275. So as you
can see, the formula adjusts as your ratio of winners to losers
changes, and also as the size of your winners and loser changes.
One final note - this topic ties in with 'Expectancy'.
Expectancy is defined as:- (% of wins x Avg Win Size ) - (% of
Losses x Avg Loss Size) = Expectancy Just remember that you
should NEVER trade with money you aren't prepared to lose!
About the author:
Trader Jack likes to write for www.traders101.com - the free
stock trading site from traders Initiative helping traders
get up to speed fast!
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