This is our second blog post on trading discipline. In our previous post on trading discipline, we had discussed the importance of adequate risk reward in trading. In this post, we shall write about the trade sizing.
You recently landed up a hefty annual bonus and want to park these funds for quick returns. Mutual funds are too conservative for you. You want quick returns; hence long term investments in stock markets do not fit your requirements. You have seen many stocks doubling or tripling over the last 6 months and expect the bull run to continue. Hence, you decide to take short term trading positions in the market.
We want to reiterate that trading is inherently risky and requires, in addition to deep understanding of chart patterns, a lot of discipline. Be advised that trading is not a quick way to make money. Retail investors, in general, lack trading discipline and struggle to keep emotions out of trading. Therefore, we do not recommend active trading to retail investors. However, if you have decided to trade actively, we suggest you work hard towards your technical analysis skills and allocate only a small portion of your investable funds towards active trading. Do not act on tips or hot stock ideas, do your homework before entering a trade and keep emotions out of trading.
You have spent a lot of time developing your skills in technical analysis. You understand the importance of a favourable risk reward in the trade but are not sure about how big a position you should take. Should you bet all your capital on a single trade or divide the capital and take multiple trades? Well, it makes sense not to put all your eggs in one basket. However, the more important part is how much risk you are willing to take on the each trade undertaken. You put all your capital in a single trade and lose 50% on that trade or divide your capital among 5 different trades and lose 50% of each of those trades. You lose 50% of your capital in both the cases. We are not arguing that you put all of your money in a single trade. We are arguing that you must not lose 50% of your capital so soon.
Our recommendation
We suggest you should not be willing to bet more than 0.5% to 2% of your capital on a single trade. The more experienced the trader you are, the more you should be willing to bet. However, in no case, should the money at risk be more than 2% of your trade capital. Let’s try to understand this with the help of an example.
Example
Suppose you have Rs 20 lacs of trading capital (funds you have kept for active trading). On a trading capital of Rs 20 lacs, you cannot lose more than 2% of Rs 20 lacs i.e Rs 40,000 on a single trade. Suppose you want to buy Reliance Industries (RIL). Suppose RIL stock is currently trading at Rs 1,000. Using your skills of technical analysis, you have identified Rs 1100 as the target price with Rs 950 as stop loss, giving you a risk reward of 1:2. To better understand the importance of risk and reward in a trade, please read our blog post. Since you can lose a maximum of Rs 50 per share and you can only lose up to Rs 40,000 (2% of Rs 20 lacs), you can buy only 800 shares (40,000/Rs 50) of Reliance Industries for the trade. Thus, your trade size, in this case, shall not exceed Rs 800,000 (Rs 1000 per share X 800 shares). So, even if you have Rs 20 lacs at your disposal, trade discipline requires you not to take a position greater than Rs 8 lacs.
Alternatively, if you had identified a trade in XYZ stock (Current market price: Rs 25, Target Rs 35 Stop loss: Rs 20), your trade size would have been 8000 shares (40000/5). Hence the total trade size would have been only Rs 2 lacs (25 per share X 8000 shares). You can see that the size of your trade position depends on both total trading capital and the trade opportunity. In the previous trade, you could have taken a position of Rs 8 lacs but in this case your trade size is limited to Rs 2 lacs. This is because in the RIL trade stop loss was 5% below the current market price while in this case the stop loss is 20% below the current market price.
Trading is about living to fight another day
You may argue that this may cost you profits in case the trade goes right but what if the trade goes wrong. This approach limits your profits but cuts your losses too. Assume a scenario where you had put the entire Rs 20 lacs in the trade (XYZ stock) and trade had gone wrong, you would have lost Rs 4 lacs (20% of your total corpus) in a single trade. Five such wrong trades in a row and almost 70% of your capital would be wiped out. You can ask any experienced trader. It is not uncommon to get 4-5 trades wrong in a row. If that happens, would you still have the courage to take another trade in the market? Not only would you be mentally shaken, you would be financially bruised too. Trading is all about living to fight another day. In you had followed the trading discipline as we have suggested, you would have lost only approximately 10% of your capital (even after getting five trades wrong in a row).
Even the best traders/technical analysts do not get all their trades right. It is not that they do not know their profession well. It is just that chart patterns (price and volume patterns) have associated probabilities of success. For example, theory suggests that higher tops and higher bottoms on the price chart point to a bullish price structure and hence the price (after occurrence of such pattern) should go up. However, this does not happen all the time. Sometimes, price goes down (after occurrence of such pattern) too. Markets have a habit of surprising participants. So, even though traders/technical analysts can identify the chart patterns, they can never be sure if the particular trade will go as expected. Hence, while trading one needs to guard against situations where the trade goes wrong and cut losses. That is why you would have seen expert traders on TV business channels giving buy/sell recommendations along with stop loss triggers.
Adopt a low risk approach with strict discipline
Technical skills and trading discipline play an equally important role in achieving trading success. Getting yourself up to the level of experienced traders in terms of knowledge may take some time but you can easily match them in trading discipline by being patient, exercising self-control and keeping emotions out of trading. Experienced traders may find out 50 good trading ideas in a week with 70% success ratio while you may be able to find only 10 trading ideas with 50% success ratio, but you have to be patient enough to take trades with only favourable risk reward, risk only a small part of your trading capital in each trade and book losses quickly when the trade has gone wrong. The size of your trade position should be a function of your trading capital and parameters of the trade identified (current price, target and stop loss). By taking these simple measures, you do not risk losing your capital too fast and in a few trades. You will give yourself a chance to be in the market for a longer time and a chance to make a comeback even after suffering initial trading losses.
Deepesh is Founder, PersonalFinancePlan.in
Source : http://www.personalfinanceplan.in
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