TheRiskBlog

Today we start a series about risk management procedures for the active trader. We will work our way through a normal trading day and for the first step in our series we look at position size and how to come up with the correct one.

Very often traders look at a chart, find a pattern that they like and put in all they have. This is fine if the stock does what it is supposed to do but it is not ok if it goes against you. You do not want to use all the money in your account for your first position not knowing where it is headed. If so, then how do we find out the correct size?

Well, this depends on the allocation method you are using in your account. For starters and to keep it simple let´s say we do not want to use more than 30% of the total for a single position. So there it is we do have our first number. The maximum we can use for our first trade is 30%. If we have $100.000 in our account, that means our first position can not exceed $30.000 with our initial investment. It can go up when it gains later on but we are not allowed more than $30.000 up front.

Now let´s further assume we want to trade AAPL long and it is our first and only trade today. The first thing we have to do is divide $30.000 (our maximum of 30%) by the price of the share so $30.000/185.38 = 161.83

We round that down to 160 and now we know that we can not trade more than 160 shares of AAPL in our account. But this tells only half of the story because we did not look at the volatility of the stock. When trading always make sure that you are trading the correct position size taking into account your account and the volatility of the stock.

In order to work with volatility we first need to know how much money we would allow ourselves to lose if that happened. Since we are at the beginning of our trading career and we still need to have money available for trading after a couple of month we do not allow more than 2% of our total account to be lost on any trade. That means we can not lose more than $2000 on any trade. Since the AAPL trade is our first trade we now know that our loss limit is set to $2000.

Now let´s look again at the chart you linked to earlier. It shows the AAPL stock and on the bottom you see an indicator called ATR or Average True Range. This indicator simply shows us the average movement of the stock over the last 14 days. If you want to know the exact definition of ATR please refer to this Explanation.

The number on the right says 3.7 (or a different reading if you open up this article on a date in the future) and we need this number for our next calculation. We simply divide our maximum loss limit of $2000 by the volatility of the stock so our calculation looks like this:

$2000/3.7 = 540.54

Now, this means that we can trade 540 shares (rounded down) of the AAPL stock today. But wait, this is more than we can have in our account because our very first calculation said we can not have more than 30% or 160 shares in our account. Since our volatility calculation came up with 540 as the result we convert that down to 160 shares right now.

Let´s have a look at what we trade now. Our calculations showed that we can only trade 160 shares of AAPL. The volatility of the stock shows 3.7, so on any given day without any special news we have to assume that AAPL shares can rise or fall closely to $3.7 a share or in our case 160 x 3.7 = $592

$592 is well within our defined loss range of $2000 so now we can go ahead and make the trade.

This is all for today, the next time we will look at more than one position in our account.

Be safe when you trade, always take care of your risk.