Lecture notes series: Percent Risk Model

I developed a habit of writing down whatever I learnt, this helps me to 'burn' the information into my mind. I did this during my school time as well. I decided to jot down what I have read from books so far in Lecture Note series. As mentioned in my previous posting, I am following Percent Risk Model for my position sizing. Of course, this is not the only model available, it is just the approach I applied in my business. I have amended the approach to suit my style. Basically, I will define initial stop level base on chart. It can be support/resistance level, straight trend line, Count back line or swing high/low.

Definition:

RISK - the point at which I will get out of the position in order to preserve my capital. It is x percent of my trading equity, for example, I will risk not more than 2% of trading equity in any trade.

Percent Risk Model - Controlling my position size as a function of the risk.

For example, with account size of $50,000, 2% of $50,000 is $1000. That means in any trade, I shall not risk more than $1000 with this account size.If I got a Long signal for SIMSCI at 289 and I have figured out from chart, proper stop loss level is at 287.5. On one contract basis, this trade requires $300 risk. With maximum risk amount $1000 available to me, I will be able to buy ($1000/$300=3.33) 3 contracts in this trade.

I quote a portion of Dr. Van Tharp's explaination from his book

'Just how much risk should you accept per position with risk position sizing? Your overall risk using risk position sizing depends upon the size of the stops you've set to preserve your capital and the expectancy of the system you are trading.'

Here goes on the explaination :

'if you are trading other people's money, you probably should risk less than 1 percent per position. If you are trading your own money, your risk depends upon your own comfort level. Anything under 3 percent is probably fine, if you are risking over 3 percent, you are a "gun-slinger" and had better understand the risk you are taking for the reward you seek.'

He explained the relationshiop with system expectancy as well:

'if you have high expectancies in your system (i.e your reliability is above 50% and your reward to risk ratio is 3 or better), then you can probably risk a higher percentage of your equity fairly safely'.

The percent risk model is the first model that gives trader a legitimate way to make sure that a 1-R risk means the same for each item he is trading. The advantage of this model is, it allows both large and small accounts to grow steadily. It equalizes performance in the portfolio by the actual risk. On the other hand, the disadvantage will have you to reject some trades because they are too risk.