This is the follow up on my Strategy Part I.
In this article I will discuss my risk management strategy. It is very closely based on “The Complete Turtle Trader” by Michael W. Covel. So far this strategy hasn’t been thoroughly tested by myself in the penny stocking realm, but it is the basis upon which trend followers such as Dennis Richards and Jerry Parker have managed to stay in the game and remain profitable for a long time. This is the risk management strategy that I have chosen to use for my day to day trading.
- N: Average true range moving average
- unit: percentage of risk to the cash in hand or equity at any given time (this value fluctuates with profit and loss)
The Risk Management Strategy
Choosing a unit
The first step in this strategy is to figure out the unit value, or more precisely the risk to equity (we’ll call it E) chosen. As I am starting, I have chosen to set myself a 1% (we’ll call it pc) risk unit on my equity.
This can be explained as follows: for an account of $10000.00, the risk unit of 1% means I only want to risk a maximum of $100.00 per trade ($10000.00 x 1% = $100.00). For simplicity, I’ll call this U.
U = E x pc
That is my risk unit. The other reason for labeling this amount a unit, is that it helps me separate from its cash value, which essentially affects the way I’ll think about the trade and won’t properly focus on the price action/technical analysis. My goal here is to demonetize my position.
Each trader will chose a unit size according to their loss comfort zone, but as a beginner, I set myself to 1% risk of my equity per unit.
Average True Range or N
The average true range has multiple uses in my current strategy, some of which are out of the scope of the risk management subject. Essentially, the average true range defines the volatility of the stock at any given time by creating a moving average of true ranges across a period of 15 days. This tells me how the price has moved on average over the last 15 days between its lowest possible values and its highest possible values. This value can easily be obtained from any trading platform as a study on a chart.
For simplicity, this has been called N.
A multiple of N is also helps in defining the absolute stop that will represent my exit price in order remain within my risk management limits for loss; our stop will be defined as xN, x being the chosen multiple
Obtaining the Position Size
Once the unit value and N and x multiple for N have been established, we are now able to define the position size; for simplicity’s sake, I’ll call it P, it’s corresponding $ value will be called $P.
P = floor(U/xN)
My choice of x is 1 in order as a beginner trader. I may adjust this value in the future.
Here is an example:
$NEON price: $3.33
N for $NEON on December 31st 2014: $0.232
x = 1
U = E x pc = $10000.00 x 1% = $100.00
P = floor(U/xN) = floor($100.00/(1 x $0.232)) = floor(431.03) = 431
$P = 431 x $3.33 = $1435.23
Essentially what this means is that the maximum risk that I’d be taking would be a $100.00 loss for an investment of $1435.23 on $NEON, setting my exit at 1N, meaning, in this case my exit price would be:
E = price – 1N = $3.33 – $0.232 = $3.098
Risk Unit Adjustment
For every drop of 10% in the original equity, the risk unit percentage is reduced by 20%.
base unit is 1% for E=$10k
Equity drops to E=$9k after losses
Risk unit is adjusted to 0.8% of E for all new trades until the lost 10% in E is recovered.
U = E x pc = $9000 x 0.8% = $72.00
For each 10% gain recovered, return to the previous risk unit percentage in order to return to the base risk unit when all gains are recovered.