A couple of weeks ago, I had a Skype consultation with “Bill.”
He’s a new trader who started over the past few months but not a stranger to markets, having actively invested in mutual funds and his retirement for a long time.
On our call, we covered a wide range but there was one topic in particular that turned into a real aha moment for Bill: position sizing and stop losses.
Bill’s been studying so he knows that risk management and cutting losses is critical to surviving over the long haul. That in itself is a great thing because most new traders only pay lip service to risk management, but don’t actually appreciate its significance until it’s too late.
So while Bill has the right intentions focusing on risk management and stopping out of positions that are going against him, his actual execution has been backwards.
How Bill Was Reacting to Risk
When Bill found a stock that fit his entry criteria he would proceed to buy a few hundred shares. If it went in his direction, fantastic, no problems.
But if the stock moved against him and he began losing money — let’s use -$300 for round numbers — he knew it was time to exit and get out.
While we were walking through his thought process in some of his past trades, I asked him why he got out of a certain position that he was describing to me.
Bill said, “Well, I was down $300 dollars so I knew I had to exit.”
And then he paused and added something very important.
“But I really didn’t want to because I still think the stock is going to head higher.”
Bill was exiting his trades when the dollar amount he was down on the trade got too unbearable to stand. What I proposed to Bill is that his risk management process start with position sizing.
I told Bill to consider “backing into” his positions by first clearly defining his exit point and then computing the number of shares to purchase based on that.
The takeaway being:
“Your exit should be at the point which invalidates your rationale for entering the trade in the first place and not at the dollar loss you can no longer stomach.”
In other words, instead of taking an arbitrary several hundred shares with a tight stop loss, a trader should figure out where exactly they’ll be proven wrong in their entry thesis, use that as where they will exit for a loss on the trade, and determine their shares accordingly. The equation should look something like this:
Position size = (Account size * Risk per trade) / (Entry – Stop loss)
Even though this way of doing things will likely lead to wider stop loss placement, you’re not increasing the risk in the trade, you’re actually lowering it.
Ok, so you may be asking yourself, did Evan really just say wider stops result in less risk?
Yes! But let’s first qualify the statement by saying I am referring to overnight holds.
Imagine you socked away 50% of your account in small cap company, ticker symbol RISK, with the plan that you were going to use a 2% stop loss on the trade. If your stop loss got hit, you would only lose (50% * 2%) = 1% of your overall account, a fairly reasonable amount for most strategies.
The problem is ticker RISK is a small cap volatile name that can easily gap up or down 5% without any newsworthy catalysts. The well-intentioned 2% stop loss is great in theory, but the overnight risks and past behavior of RISK raises the odds greatly you’re actually going to take a loss bigger than you had planned — or potentially take something very devastating if a large overnight move occurs.
Instead, imagine you looked over RISK’s prior trade history and recognized that a 10% stop loss is much more appropriate given the stock’s volatility. If you used a 10% stop loss you would only need to invest 10% of your account in this trade (as opposed to 50%) and if the trade does end up hitting your stop loss you’ll still only lose that same (10% * 10%) = 1% of your overall account value.
The somewhat hidden but very important benefit, however, is that if you position size the second way, it will greatly reduce the impact a large overnight gap down will have on your account.
It clicked instantly for Bill. He understood exactly what he had been doing wrong and now he knew what he needed to do going forward. I sent him a copy of the Trade Risk’s position size calculator which is designed to solve this exact problem by incorporating multiple risk constraints, for a meaningful yet responsible amount of exposure in each individual trade.
An important note, this all assumes that Bill has a positive expectancy system and that his discretion and decision making is assumed to be true (value-add). But that’s a topic for another blog post, or in Bill’s case another consulting session.
Position Size Versus Stop Loss Tug of War – Conclusion
Assuming you are not a systems trader:
If one of your positions is selling off but you still think the stock should head higher (which we’ll assume is the reason you bought in the first place) then you should not be exiting the trade at that point.
Exiting a position you are bullish on means you have a position sizing problem, or one of several possible behavioral issues you need to straighten out.
The solution is to take less shares, widen out the stop loss to whatever is appropriate for your trade setup, and only exit when the market has convinced you that you were wrong in your entry rational.
This is an important lesson and one that took me years to learn the hard way. Does this make sense to you? Do you have any follow up comments? Leave them below, I’d love to read them.
If you think you could benefit from a one-on-one review of your process, check out our consulting sessions.
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