Let's have a look at an example trade

Looking at the above chart we will calculate the risk for a trade on ION. Our entry point is $3.01 or higher. Our exit point if the trade goes wrong is at $2.89. Our maximum loss that we will take on this trade is 12 cents plus slippage and brokerage. Let’s allow slippage of 2 cents and brokerage of $100 per trade.

Maximum acceptable loss is $500
Brokerage is $100
Maximum loss between entry and exit is $400
Difference between entry price and exit price, incl. slippage $0.14
Maximum parcel size permitted = 400/0.14 which equals $2857

In this example we can place just under $3000 in the trade and stay within our risk tolerance. If we were to place more than this on the trade then we would be exceeding our acceptable risk. If the parcel size is too small then it may not be worth entering the trade. The minimum parcel size that works in reality is in the region of $3000. Using a parcel size smaller than this could mean that our gains are not significant enough in dollar value to cover our costs of trading.

Tighter stops mean more on the trade with the same risk

Let’s consider that we were prepared to use a tighter exit if the trade goes wrong. Entry point $3.01 exit point $2.99. Slippage and brokerage remain the same as before at 2 cents and $100. This time we will lose a maximum of 4 cents if the trade goes wrong.

Maximum acceptable loss is $500
Brokerage is $100
Maximum loss between entry and exit is $400
Difference between entry price and exit price, incl. slippage $0.04
Parcel size permitted = 400/0.04 which equals $10000

We can now place a parcel of $10,000 onto the trade. A much larger parcel but we are taking the same risk if the trade goes wrong.

Now that we have an understanding of how to calculate and manage our risk the big question is why does this work? Why is this strategy so effective? The reason for this is that we can never be sure upon entering a trade whether it will go well or not.

For the trades that do not work out and we stand to lose more we have less capital committed to them. For the trades that do not work out and we stand to lose a smaller amount we have more capital on them.

Learning to place the maximum on a trade without increasing your risk

This allows us to place a maximum amount onto each trade while fixing our downside. With the equal position size model we do not maximise our parcel size as it remains constant regardless of the risk on a particular trade.

It is important to note that if you follow the 2% rule religiously you could have 100 losing trades and still have some money left. Most traders risk far too much on a trade and many can get caught out in a dramatic move against them.

Following strict risk management rules will improve your results and a little bit of months when you enter a trade could dramatically improve your returns.

Jeff Cartridge
LearnCFDs.com

5 February 2009

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