Market Talk with Piranha is currently moving to its new home at chrisperruna.com. The new site is up and running but many of the posts need editing as the images and stock charts did not transfer successfully (thanks blogger). I will post all new entries to both blogs – Thank you for your patience while I make this change!

Wednesday, March 15, 2006

Position Sizing - Why Losing isn't Everything!

I have been arguing (going back and forth) with a “so-called” investor on another forum and he questioned my trading methods and claimed I would lose 76% if I took 8 consecutive 8% losses. Knowing me, I had to breathe deeply, release the anger from a person who knows nothing about position sizing and teach him a simple math lesson. The following example is simplified to allow you to understand what is happening. In the real world, things are a bit more complicated with commissions, emotions, slippage and the like.

Enjoy the position sizing example. It shows you how you can lose 80% of the time (worse case scenario); yet still come out a slight winner.


If I start with $100,000 and lose 8 consecutive trades at 8% (only risking 3% of capital with 8% stop loss), this is what it looks like:
$100,000 portfolio
3% risk per trade
8% stop loss

1st Trade:
Risk will be $3000 = ($100,000*3%)
Amount to Trade at 8% stop: $37,500 = ($3000 / 8%)
An 8% stop loss will cost me $3000

2nd Trade:
Risk will be $2,910 = ($97,000*3%)
Amount to Trade at 8% stop: $36,375 = ($2,910 / 8%)
An 8% stop loss will cost me $2,910

3rd Trade:
Risk will be $2,822 = ($94,090*3%)
Amount to Trade at 8% stop: $35,283 = ($2,822 / 8%)
An 8% stop loss will cost me $2,822

4th Trade:
Risk will be $2,738 = ($91,267*3%)
Amount to Trade at 8% stop: $34,225 = ($2,738 / 8%)
An 8% stop loss will cost me $2,738

5th Trade:
Risk will be $2,655 = ($88,525*3%)
Amount to Trade at 8% stop: $33,198 = ($2,655 / 8%)
An 8% stop loss will cost me $2,655

6th Trade:
Risk will be $2,576 = ($85,873*3%)
Amount to Trade at 8% stop: $32,202 = ($2,576 / 8%)
An 8% stop loss will cost me $2,576

7th Trade:
Risk will be $2,498 = ($83,297*3%)
Amount to Trade at 8% stop: $31,236 = ($2,498 / 8%)
An 8% stop loss will cost me $2,498

8th Trade:
Risk will be $2,423 = ($80,798*3%)
Amount to Trade at 8% stop: $30,299 = ($2,423 / 8%)
An 8% stop loss will cost me $2,423

Total loss after 8 trades: $19,201
This loss totals 19% (minus commissions etc…)

TRADE #9:
Risk will be $2,351 = ($78,374*3%)
Amount to Trade at 8% stop: $29,390 = ($2,351 / 8%)
An 8% stop loss will cost me $2,351
**This trade ends with a 40% gain: $11,756 = ($29,390*40%)**

Original amount: $78,374 + $11,756 = $90,130

TRADE #10:
Risk will be $2,703 = ($90,130*3%)
Amount to Trade at 8% stop: $33,787 = ($2,703 / 8%)
An 8% stop loss will cost me $2,703
**This trade ends with a 30% gain: $10,136 = ($33,787*30%)**

Total portfolio worth: $100,266

WOW – a profit with 8 consecutive losing trades and 2 winning trades!
That is a 20% winning percentage but it gave me an end result of a slight profit!

This is how money management works!

Now just imagine have a winning percentage of 40% or greater and cutting some of those losses at less than 8%, your portfolio could easily gain 50% or more in one year with a 40% winning percentage based on simple position sizing!

This is how TRUE investors and traders take money out of Wall Street.
Piranha

4 Comments:

At 2:34 PM, Anonymous Anonymous said...

Won't your portfolio consist of very few stocks using 3% risk and an 8% stop loss? Your first position is 37,500 or over 1/3 of your total portfolio value.

 
At 3:03 PM, Blogger Chris Perruna said...

You are correct; I was only showing a hypothetical scenario to prove a point. I have discussed the topic in the past with different risk factors, portfolio size and stop loss numbers. The idea is to teach the lesson rather than give exact scenarios. I was exaggerating with a worse case scenario.

 
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