Sponsored Link:
Risk Management and Position Sizing
The Smart Profits Report: Issue #355
Wednesday, September 20, 2006
Risk Management and Position Sizing: Three Ways To Give Your Trades A Tune-Up
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research
What could you buy if you had an extra $4.5 billion?
I did a little research, and have a few suggestions:
- You could but a brand new Porsche Boxter for every man, woman and child in New York’s capital city of Albany - and have $200,000,000 in change.
- You could fund the total economy of Martinique, Somalia or Barbados (by matching their GDP) and let everyone take the year off.
- You could buy the following companies for cash: Guess?, Inc., and Scotts Miracle Grow.
$4.5 Billion is a lot of cash. Almost unfathomable. But the Amaranth hedge fund lost that amount in just one week. The trader that lost all that dough was up $2 billion for the year, so I guess he got lost in all those zeroes. But he apparently absorbed that huge loss by ignoring the simple rules of proper risk management and position sizing.
Fortunately, you don’t have make the same mistake to learn about poor position sizing Let’s look at how the loss unfolded and, more importantly, how you can employ prudent risk control in your trading….
You Don’t Have To Be A Gunslinger To Be A Great Trader
Congressman Everett Dirksen is often credited with the phrase: “A billion here, a billion there, and pretty soon you’re talking real money.”
It sure seems like the trader at Amaranth prescribed to that theory.
He was known as a gunslinger, often taking huge positions, especially in futures contracts that had long-term delivery dates. Some also saw him as an innovator, adding liquidity to markets where none existed before.
But in this case, “innovation” was just a euphemism for poor position sizing.
According to the Wall Street Journal and other sources, Amaranth is not revealing the details of the series of trades that went badly awry. The best guess is that nobody wanted to take the contracts off of Amaranth’s hands in such large volumes and so far out.
And when the trouble came calling, the firm suffered the double-whammy of poor position sizing and lack of liquidity at the same time.
So what can you do to manage risk and protect your portfolio from a taking a similar hit? Here are three simple suggestions:
Risk Management 101: Know Your Risk On Every Trade
This might sound simple, but many people enter a trade without knowing the precise point where they’ll get out if the trade moves against them. This is typically called a stop loss.
If your strategy doesn’t include a protective stop loss, then drop everything right now and add this critical rule to your list.
Optimal Position Sizing: Risk A Small Amount On Any One Position
As a guideline, you should risk a maximum of 1-2% of your equity on any one position or idea. And there are several good reasons for risking this small amount on every trade or investment.
The first reason is that you can sustain many losses in a row without blowing out your trading account. The second is that if unexpected events occur that cause large fluctuations well beyond your intended exit point in your investment, you may lose two, three or four times your intended amount. But if that initial risk amount was only 1%, then it’s not catastrophic.
Seasoned investors and traders may go as high as 2% risk, but only then for proven strategies. In the classic book “Market Wizards,” many legendary investors state that risking more than 2% on a trade is just gunslinging.
Lacking Liquidity: Understand The Risks In Your Positions
Not many of us will trade natural gas contracts far into the future like the Amaranth trader, but there are other instruments that suffer from similar “lack of liquidity” problems.
If you trade penny stocks or options that are out of the mainstream, make sure you adjust your position size to account for increased “slippage” (the difference between where you want to execute your trade and where it actually happens).
Don’t wait for a costly lesson to come along and shock your system. Practice good position sizing techniques today for sustainable profits.
Good Trading,
D.R. Barton, Jr.
|
Today’s Smart Profits Cribsheet I’m not the only one who believes in the importance of position sizing. Mt. Vernon Research Chairman Karim Rahemtulla thinks this is actually “the most powerful investment concept.” Find out more in Smart Profits Report #193, Position Sizing: The Most Powerful Investment Concept. Related Articles:
- Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio
- Trailing Stops: How to Give Your Options Room to Grow
- Exit Strategies: Prenuptial Agreements for Options
The Chart of the Week
Yahoo! (NASDAQ:YHOO) took a major hit today (down $3.25, or 11.2%, to $25.75) after it warned of lower ad revenue growth. However, it could not break below its July lows of $24.91. Look for that level to hold and YHOO to rebound from here. If that level doesn’t hold, then look out below…
Sphere: Related Content
