On 13th June Alpesh Patel wrote an article for Msn Money about how to handle the FTSE when it is on a rollercoaster ride. According o Patel the only way is PPP: Plan, Prepare and protect. He says that if you risk too little on each trade the returns will be too low to overcome transaction costs, small losses and overheads (quote feeds, electricity, rent, costs of books and so on). While studying finance it is often taught “High Risks High Returns” but one bad trade can put you in dangerous waters. Traders use different formulae to work out how much money they should put on any trade. Gibbons Burke provides one such useful formula.
S = re/p
Where:
- s = size of the trade
- e = portfolio equity (cash and holdings)
- r = maximum risk percentage per trade
- p = entry price on the trade x = pre-determined stop loss or exit price
Gibbons Burke gives the following example; “Belinda has a trading account with a total value (cash and holdings) of $100,000 and is willing to risk 2% of that capital on any one trade. Her trading system gives her a signal to buy DTCM stock trading at $100 per share and the system says that the reversal point on that trade is $95. Plugging this into the formula tells Belinda that she can buy 400 shares of DTCM. The cost of this investment is $40,000, but she is only risking 2% of her capital, or $2,000, on the idea.’
“Belinda then gets a tip from her brother-in-law that KRMA is about to take a nose dive from its lofty perch at $40 because he heard from his barber that earnings of KRMA will be well below expectations. She’s willing to go short another $10,000 of her stake on this idea. She studies a KRMA chart and can’t see any logical technical points that would be a good place to put in a stop, so she uses the money management method to determine the stop according to this formula:
x = p(i-er)/i
where:
- x = pre-determined stop loss or exit price
- p = entry price on the trade
- i = investment amount
- e = portfolio equity (cash and holdings)
- r = maximum risk percentage per trade
“Since she’s shorting KRMA, the value for i, $10,000, should be negative. Placing these figures into the formula tells Belinda that her stop price on the short sale of KRMA should be 48. If she didn’t want to assign a high confidence on this trade she could reduce the max risk to 1% (r=0.01), which would bring the stop down to 44.”
It is important to keep an eye out for danger and determine when to adjust your stop prices as the market moves in your direction.