Managing Your Trade Size And The Trade itself

Trade management typically is separate from how much to risk per trade. However it is very connected as your overall understanding of what percentage of your bankroll you lose depends upon both what percentage of capital per trade AND where your stops are set.

Basically the "exit strategy" more or less defines the bulk of your trading system with how much to risk per trade determining if you maximize profit, or minimize your chances of loss or somewhere between depending on comfort level. Of course risking too much actually minimizes your chances of gain and increases your chances of loss over time, but that obviously is not a good strategy.

A Fellow Blogger at IBDindex.blogspot.com writes a great posts of using multiple exits and using multiple exits part 2. The strategy is pretty interesting in how you can offer 6/1 reward to risk with a near 30% win rate. This is a pretty good trend following strategy. Now based upon what I know about "kelly criterion", I would determine how much capital to put into a trade at once using these stops a bit differently. It would depend upon correlation.

Lets just use a 60% correlation and $5,000 account. Then I would need some estimates. I estimate a 10% chance of a worse than 8% loss which I will put at 15%. I estimate a 60% chance of stopping out (60+10=70% and win rate is nearly 30%). That leaves 30% of a "win". I determined 2 possible wins. One a win of 30%, another a win of 65%. The win of 30% happens 20% of the time, and the 65% win only happens 10% of the time. Now you theoretically could put 100% of your capital to work, 8% of which would be at risk. In this case, there is no reason to diversify into multiple trades simultaneously other than reducing risk. The actual return would be maximized at 1 trade since fees are involved. However, at the equivalent of say 25% of capital at risk for 1 trade, we can put 6 trades on of nearly 8% of the bankroll per trade for a total of 47.88% of capital at risk and 52.119% in cash.

This strategy would return over 1.7% growth on bankroll per "trading period" as opposed to the normal fee adjusted 1.14%. If such a system averaged a holding period of 1 month, then 12 trades over a year would return 22.53% on bankroll as opposed to 14.63% with just one trade. On the other hand, were you to put 100% of capital at risk divided into 6 bets, you would return 67% per year with capital divided into 6 bets, as opposed to 84.57% with them concentrated to 1. However, in this case, the risk of spreading it into 6 bets as opposed to putting it all into one would produce much lower volatility then 100% of capital into 1 trade since the maximum is capped at 100%.

Now I realized that my win% was 5% too high as it is closer to 25% than 30%. So I adjusted it to 65% chance of 8% loss and a 17.5% chance of a 30% gain and only a 7.5% chance of a 65% gain. Now only 3 bets works with equivalent of 25% at risk and only produces a 9.28% annualized return with 38.125% capital at risk per trading period as opposed to 7.94% for 25% risk for 1 bet which is roughly the equivalent at risk. Alternatively with 3 bets risking 33% of portfolio each you can return 37.084% or 1 bet with 100% at risk and return 46.58% per year at greater portfolio volatility and risk.

It's important to manage your trade with an exit strategy that works, but also to manage your position size to accord with the risks. There are much different risks not considered, mainly being the risk that the return is nowhere near as good as the test period, or that often enough the system results in gapdowns below 8% or even worse below the 15% we planned for, that it may drastically impact the strategy and cause too much capital to be put at risk.

As you can see exit strategy is very important in defining overall return over the long run. It is the proper exit strategy that can make a huge impact in whether or not you are a winning trader, even if your entry criteria provides better than average opportunities.

Nevertheless, we can look at other trend following strategies and see they could produce a much worse return, particularly with so much at risk.  It is certainly possible that better alternatives are out there, but this is probably the money management strategy you want to use, or something similar that lets winners run. The actual position sizing strategy depends upon the overall odds and possible outcomes within the strategy and when in doubt, risking less capital is usually best. The best chart pattern high tight flag is a great way to consider identifying stock and finding entry points. In the next post we will look at further advancing this strategy.