Sophisticated investors always consider portfolio mix as part of their strategy. Sometimes it’s to diversify, other times to weight more heavily into expected growth sectors, maybe balance growth and income classes but always it‟s with a view to balancing risk factors.
As derivatives traders, we seek to ride the underlying products that are going to move the furthest or at least with more certainty and are prepared to invest more money into these with less regard for overall balance as we are only in the trades for minutes to months. This adds another degree of risk and one critical and easily achievable way of reducing this risk is to manage the amount of money risked in each trade.
Determine the portfolio leverage you want to risk and stick to it
Beginner traders put ‘equal dollar’ amounts into each trade e.g. $5,000 parcels so it’s easy to see how much they have made or lost based on the current valuation. Unless their stop loss is always placed a set percentage away from the entry price, a tighter stop will decrease risk but a broader stop (which is what is often required) will incur a bigger loss if triggered. Assuming the stop is say 4% away from the entry price and your account is leveraged 5x, if you have 3 similar trades overall then you are risking 20% on each trade and 60% of your float on these 3 trades alone. Of course you can make this type of money as well, but we have already seen its more important to protect your money than chase higher profits. Trading is a numbers game and CFDs are not very forgiving if you get it wrong and have big positions open (relative to your float).
A better way is to risk a set amount each trade so that you can withstand 3, 5 or even 15 losses in a row and still be in the game with enough money to recover. Your losses will be reduced, as will your profits but small profits are always going to be better than big losses and you need enough money in your account to rebuild when the winners start.
So how much do we risk? Well of course this is up to you and your strategy but it is widely written that a good amount is 2% (risk of your float per trade position). So you can see you can now take a string of losses and still have a viable float to continue trading and at the same time, when profits go up 2%, 5%, 10% or more and you have leverage working for you, your profits can soon add up.
If you don’t want to do the math each time, following is an excerpt from a free website that will do it for you.
With a $5,000 account, a $2,000 position size (bearing in mind typically only $200 would be used as margin) this could be considered too small without knowing the reason why. Again our focus is on risk management and position sizing is one of your key survival skills and one that traders ignore at their peril.
Here we have the same scenario and risk percentage on the left but on the right we have a different stop loss position and so we can now take a larger position size and will make a larger profit should it go in your direction.
This position sizing is a key survival tool so make sure you understand it and commit to using it and calculate the numbers yourself or use www.cfdcalculator.com for free or they have a low cost software version to load onto your computer.
We haven’t taken into account brokerage costs or slippage here and it just complicates the maths further so if you are concerned, then reduce the risk percentage to have some allowance for the additional costs. In practice though, we are managing our risk and the ‘costs of doing business’ are simply that – just costs to be managed and seen in perspective.
Experienced traders with larger floats often reduce their risk further to only 1% or less and due to bigger accounts they still do very well with little risk should the trade go against them. Newer traders usually have smaller floats and while risk reduction is still the same goal, return for effort also steps in so you may be tempted to go out on a limb and increase your percentage risk. Try some different numbers on the CFDCalculator.com website until you find a comfortable position.
As you become more advanced you can look to create higher yielding strategies that still control your initial risk. As an example: risk say 1% of your portfolio per trade initially, and then when the CFD has hit a the first profit target and the stop loss is moved up to break even, risk another 1% plus the unrealised profit on the first leg to take a bigger overall position. This way you preserve capital but when a market is running strong, you get to take greater advantage of it. This is a form of „pyramiding‟ and you can read more about this topic elsewhere. The best source of information I have found on position sizing is Van Tharp‟s work. He has written 3 books and my number one trading book is his ‘Trade Your Way To Financial Freedom’ which was updated in 2007 and well worth the $50 you will pay for it. He also has a website and newsletter being www.iitm.com