Position sizing tight stops on non-leveraged stocks

[contrarian]

I'm working slightly backwards to the usual order it's done in.
Okay - you have $100,000

You've decided you need at least 10 positions to diversify, and have a rule saying something like, "no more than 3 trades in the same sector."

You also have a "max bet" or position size of $10,000 rule to accomplish the minimum 10 stocks rule.

This is pretty simple, sensible & standard stuff (from what I've read anyway).

You want to use the standard old 2% rule.

Okay now, if you were doing some longer term investing and your stops were really wide (you may have even picked an arbitrary 20%) this is fine.

But anything less than that and (due to the max bet rule) you'll NEVER be risking 2%.

Example: say your stop averages out to 5%.
(a) You will always have a position size of $10,000 (which is not a problem), and
(b) Your (average) risk will only be 0.5% - HALF OF ONE PERCENT! (Also means your portfolio heat is only 5%).

Now, this is a problem, no? We're not:
(1) risking enough per trade, nor do we
(2) have enough portfolio heat.

And there is no way to change this without changing the rules.

So: is this (lack of risk) a problem, or not? If it is a problem (inefficient), what's a better way?

Cheers,
Steve

[Nathan]

"So: is this (lack of risk) a problem, or not? If it is a problem (inefficient), what's a better way?"

If this is or is not a problem is a question to ask yourself, I have no clue how someone could try to answer this for you, as it relates to your own goals, desire for risk, ect.

WHen you construct a money management scheme, you have to look at the realities of the markets you are trading.

the % risk method common in futures can to some degree be limited by the margin limmitations on owning stocks, and in your case the rules you had previously established. In this context Your rules are to some degree working at contradictory ends, unless you are using them as limmits rather than intended or ideal risk levels.

I don't know but it seems that you are throwing together random trading rules, then asking "is there a better way".

Well, yes, a better way is to develop a trading plan in a methodical, non ad-hoc fashion based on the realities of the market rather than arbitrary rules.

[contrarian]

Do appreciate the response Nathan, but I feel that you have not understood where I'm coming from, & therefore have not actually answered the question.

The realities (as you put it) of the market (in this case, the stock market - non leveraged) dictate that tight initial stops pose a problem when attempting to position size according to a fixed-fractional allocation (e.g. the "2% rule.)

You seem to have not considered this problem thoroughly.

Cheers,
Steve

[Forum Mgmnt]

Steve,

This is really an issue that arises from the much lower leverage available for stock trading in most instances. So the constraining factor becomes the equity available for investment rather than the risk you want to take.

If you could borrow money to purchase as much as you wanted the problem changes.

If you remove equity as the constraining factor, the 10% limit forces a lower per-trade risk unless you are dealing with relatively large stops or very cheap equities. To improve returns, you then need to increase the number of trades you are willing to take at the same time in order to maintain the same aggregate risk. In your example, 40 markets at 0.5% would give you the same 20% aggregate risk as 10 markets at 2%.

There are ways for non-U.S. investors to get better leverage than the 2 to 1 limit imposed by the SEC including CFDs and spread-betting but these have other risks and issues.

Bottom line, don't expect returns in stocks to equal those in instruments that afford much higher leverage.

The other issue is that even if you limit sector exposure, equities correlate highly so you don't get the same level of true diversification as you get when combining very uncorrelated markets like soybeans, coffee, and interest rate futures. This reduces the potential risk-adjusted returns.

If you want to make high returns in equities you have to be more sophisticated. The simple approaches don't offer the same level of return in equities as they do in futures.

- Forum Mgmnt

[MCT]

There are ways for non-U.S. investors to get better leverage than the 2 to 1 limit imposed by the SEC including CFDs and spread-betting but these have other risks and issues.

hi c.f.

The above is music to my ears. Do you know how much better? And what avenues are you referring to?

This SEC imposed limit is the only reason I utalize stock options for the pure purpose of attaining higher leverage than I'd otherwise be able to obtain.

[Nathan]

your rules and your intent are not in harmony.

If this is not what you want, then you reconfigure your rules. Its that simple.

The optimal solution you invision in your head may or may not be possible given the realities of trading the markets.

c.f. mentioned Cheap equities. This can potentially be a pretty decent solution if you scan to get the volume and volitility you need.

[contrarian]

Forum Mgmnt,

Thanks for the honest answer, esp.

Bottom line, don't expect returns in stocks to equal those in instruments that afford much higher leverage.

I found this especially interesting:

If you want to make high returns in equities you have to be more sophisticated. The simple approaches don't offer the same level of return in equities as they do in futures.

I find this intriguing as the natural thought is that strategies should work the same across futures & stocks (e.g. look at a bunch of stock or futures charts and you can't tell the difference). You seem to be inferring that this is not the case & that other factors (company fundamentals, perhaps?) may play a greater part in trading stocks. This is something I have wondered about for a long time - it has always seemed to me that those espousing mechanical methods & simple systems are near on always futures traders, and so I have always had the feeling that stocks and commodities really are different (from a trading perspective). You seem to be saying this is the case. I'm actually a bit surprised! Especially that simple, "few rule" systems won't work well on stocks?

Cheers
Steve

[contrarian]

MCT,
where are you? In Australia the 2 biggest players would be CMC group & IG Markets, with others coming on board as well (Mann financial, GETfutures).

If you're in the UK, you'd have even more choice I'd imagine.

Leverage can be 10/1, and with some companies, 20/1!

Cheers
Steve

[MCT]

Steve,

I guess, I’ll find out soon enough what options the UK has to offer. I’m moving to London in a few months time.