Minimize loss = Position Sizing and Stop Loss Limit by Alvin Chow

Alvin Chow writes informative articles on themes of interest to investors. He is the founder of BigFatPurse.com , loves the financial market, and curious to find out what work and what doesn't work in investing.

Minimize loss = Position Sizing and Stop Loss Limit

08 May, 2009 Alvin Chow 

William O’Neil said that, “The whole secret to winning the stock market is to lose the least amount possible when you’re not right.”

A successful trading system hence must be able to reduce losses in order to preserve the capital as much as possible. Losing 10% of your capital will need 11.1% to bring you back to your original capital.  The problem about trading is that you can never be 100% right, hence, it is very important to minimize the loss when you are wrong.

There are 2 critical elements that must be present in every trading system in order to minimize risks and losses. Not in the order of merit, the first element is position sizing. Position sizing is about allocating the amount of trading capital to a counter. There must be a rule that states the maximum amount of capital the trader can place in one trade. This is to prevent the trader from overexposing himself to a particular stock and result in a heavy loss when this particular stock pick is wrong.

The second element is stop loss limit, which is a percentage/price that will relinquish the stock holdings when triggered. For example, buying a stock at $10 and setting a stop loss limit of 8% will result in a stop loss price of $9.20. The stocks will be automatically sold if its price goes below $9.20. 8% is then the maximum risk that you are willing to take in order to play the game.

A system using both position sizing and stop loss limit will further reduce risks in trading which I will illustrate in the following example:

System A has a maximum position sizing of 25%.
System B has a stop loss limit of 8%.
System C has a maximum position size of 25% in a single trade, and a stop loss limit of 8%.

Trader A, B and C each began with $10,000 as trading capital.
Each bought the same stock priced at $10.

Trader A placed a trade of $2,500.
Trader B placed a trade of $5,000 and a stop loss at $9.20.
Trader C placed a trade of $2,500 and a stop loss at $9.20.

Unfortunately, all of them were wrong and the stock dropped from $10 to $9.

Trader A lost $250 (2500 – 2500/10 x 9)
Trader B lost $400 (5000 – 5000/10 x 9.20) Got out at 9.20
Trader C lost $200 (2500 – 2500/10 x 9.20) Got out at 9.20

You can see clearly that Trader C suffered the least lost as he used a system with both position sizing and stop loss limit. These two elements work in tandem so make sure you have them in your trading system.

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Source: http://www.bigfatpurse.com/2009/05/minimize-loss-position-sizing-and-stop-loss-limit/