When a trader subscribes to The Wagner Daily, our nightly stock trading newsletter, we send a list of four important rules that should be followed in order to be consistently profitable and effective with our trading system.
After recently becoming a new member, a trader named Keith asked us a question about rule #1 (we encourage all subscribers to ask lots of questions).
Since we thought other traders may have a similar risk management question, we decided to share with you our response to Keith, right here on our blog.
Continue reading to see our detailed answer to a frequently asked question about capital risk management.
BONUS: We also show you an easy formula for quickly determining how fast a stock moves.
Rule #1 from “Top 4 Rules For Maximum Success With Morpheus Trading Group”
Below is the first rule we email to all new Wagner Daily subscribers:
We recommend that new traders risk a maximum of 0.5% to 1.0% the total value of your brokerage account per trade entry.
Experienced traders may risk up to 2-3% per trade.
For example, if you have a trading account with total value of $20,000 and you are limiting your risk to 1% per trade, your maximum capital risk per trade (for a full-sized position) would be $200.
This is the amount you would lose if the trade hits our predetermined protective stop loss after entering.
Under no circumstances should a swing trader exceed a maximum risk of 3% of total account value per trade.
When risk per trade is too high, it only takes a few losing trades to quickly dig a significant hole.
QUESTION: Does stock price affect maximum dollar risk per trade?
Below is the exact question that Keith asked us:
If I could ask a question on Rule 1 please: With a 20K trading account and a 1% risk tolerance=$200 maximum risk per trade.
Does this rule permit any dollar amount on the trading position with the qualification that, once the stop loss hits and sells, the total loss would be $200 or less with that position change??
Ex: a $5000 trade with a stop loss 4% below the share price as purchased would permit a $200 loss (plus trading fee).
In a buy market, with IBD suggesting 100% investment, theoretically, would 4 trades (with technicals and fundamentals at the top of the IBD charts), allowing for $200 risk each, is this in keeping with Rule 1?
Swing lows might alter the 4% stop loss, but wanted to understand how I could safely put the maximum amount of the $20K account to work.
Of course, all of this example is best case scenario, and I am just getting my feet wet!
I feel like I would prefer to harmonize with O’Neil’s CAN SLIM system for core trade positions. Please feel free to tone me down, Rick! 😃
ANSWER: It does not make a difference, but beware of high-priced, low-ATR stocks.
Here’s the reply Rick (our head trader) delivered back to Keith:
“The actual price at which you purchase a stock does not matter, as it would equal a $5,000 position regardless (never be fooled by thinking a stock is just “too expensive” to buy).
But in general, be careful of higher priced stocks that do not trade with much of a daily range, as they can take up a lot of capital and do not move fast.
This lowers the odds of you capturing a big move in a short period of time.
For us, a good rule of thumb is to avoid stocks that trade at more than 50-60x the 20-day ATR (Average True Range).
Our simple formula for calculating how fast a stock moves is to simply divide share price by ATR.
For example: $40 share price / 1.5 ATR = 27x.
The lower the result of the calculation above, the faster the stock moves.
A 45 to 60 reading would be a bit slow. 30 to 45 = average speed. 20 – 30 = fast moving stock. Below 20 is potentially too fast and too volatile.
The CANSLIM system taught by William O’ Neil recommends a constant dollar position sizing model with the account divided into equal slots.
But with the CANSLIM model, stops are capped at 8%. If followed, that would lead to a loss of $400 on a 5k position, or 2% of a 20k account .
A 20k portfolio divided among 4 slots of 5k would be too aggressive of an approach if maximum risk on any one trade is limited to 1% of account equity.
With a 5k position, a trader would be forced to set stops no further than 4% from the entry point, which would be unrealistic in 8 out of 10 trades, as most of our stops are in the 4-8% range.
In order to keep the trade risk in line at 1% of account equity per trade, the number of positions in the portfolio could be increased to 8, which would lower the position size from $5,000 to $2,500 and allow for a max 8% stop from the entry.
Although we post the share size as a percentage of the trading account, we actually determine share size of trades a bit differently than CANSLIM.
We employ a fixed dollar stop loss for every trade, rather than a fixed dollar position.
With our sizing model, every stock will have the same dollar loss per trade (if stopped out), but the position size will differ depending on the distance between the entry and stop.
Most of our trades risk about 0.5% of account equity, which is about $250 on $50,000 account.
With every trade, we take the entry (30.00) minus the stop (27.85) = 2.15 points and divide that by our $250 max loss per trade to arrive at share size. Example: $250/2.15 = 115 shares.
This is why all position sizes in the account are slightly different, as we try to keep risk a constant.
With the CANSLIM/IBD approach, all positions are of equal dollar amount, but the risk per trade varies depending on distance from entry to stop.
Still, there is no right or wrong approach to position sizing.
Simply pick the model you feel most comfortable with, and be consistent to stick with it.”
Which methodology of position sizing do you prefer for keeping risk in line? Please share your thoughts by dropping a comment below.