Wednesday, December 3, 2008

Managing Loss and Position Size

Here is a simple way to manage your trades and your losses.

This is a VERY simple but helpful calculation that will make sure you take a limited loss and position yourself accordingly.

Desired Wiggle Room * Position Size = Max Loss

I use 'Desired Wiggle Room', as the amount which the stock can go against you before you invalidate a trade and call it quits.

Position Size = Max Loss / Desire Wiggle Room

As long as you know any two of these variables the other one should be easy to calculate. My preference would be to use this formula to determine my position size. Say I wanted to short GS as a day trade. I am only comfortable losing $300 on a trade before I give up on it. GS is trading at 68.9 and I think it has run out of steam. It could break above 69, but should quickly fall back down. So I want to allow this trade to go has high as 69.2 before I admit defeat. With this in mind I can position myself accordingly:

Position Size = 300 / .3 = 1000

So I can take 1000 shares short at 68.9 and have a stop at 69.2. This will limit my loss to $300 (assuming stop is hit exactly at 69.2 which it probably wouldn't).

If I feel like the position size is too big, or my 'wiggle' room is not sufficient, I can always change these params. Say I wanted to allow GS to run to 92.4 before giving up.

Position Size = 300 / .5 = 600