# The 2% Rule and leverage



## Trembling Hand (15 April 2008)

The oldest mistake in the game is the position sizing rule. From discussions in other threads about the dangers of leverage it is clear that people think because they(CFDs Futures etc) give you huge leverage that means you can take on large trading size. This is wrong. 

If you take the simple rule as risking no more than 2% of your account on any one trade it simply doesn't matter what you use to trade you will always purchase the same amount of shares if you are using CFDs, Margin loan or direct share purchase. THIS IS VERY IMPORTANT. IN FACT THIS IS THE MOST IMPORTANT THING TO TRADING.


you can play with this excel sim 

Put in 6% risk per trade and run the sim 5 times. You will blow up on my testing 2 out of 5 trials even with a positive expectancy. Then put in 2% you may lose but not blow up.

Its not sexy but it works. no more than 2% of your account on any trade.


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## Trembling Hand (15 April 2008)

*Re: The 2% Rule and leverage.*

Here is a worked example to show you if you use the 2% of account risked per trade it doesn't matter what you use to trade you should only ever buy the same amount.

$10,000 account. Max risk per trade 2% of $10,000 is $200.

Stock price at $2.00
Stop price at $1.70 

Stop value $0.30

$200 / $0.30 = Max amount of shares which is 666 Shares

No matter what you use to trade, CFDs, Margin or direct shares.


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## ezyTrader (16 April 2008)

Hi TremblingHand,

Thanks for the great-est 'guideline'. May I just ask further, to mitigate risk, for the same portfolio size, would you have a guideline for maximum CFD open positions at one time?

Cheers,
ET


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## Trembling Hand (16 April 2008)

That leads me to what my next point. What the hell is leverage used for then??

Two examples. 

First. You can purchase something that is larger than you account size and still only risk 2%. Like the SPI futures. The value of that is around $137,500 but you only need $6250 margin to trade it. But really these numbers are irrelevant. What you need to look at is account size and risk per trade. So if you have $20,000 in your account you can trade 1 contract and risk a $400 per trade or 16 SPI points as a Max stop. *The Margin has no relevance to any calculations.*

The second thing is you can take on more positions. If you are trading CFDs then you could have 3 positions open when you only have the cash for 1 direct share. As long as you still have your stop for each trade @ 2% of account. BUT this is a little tricky. *As most stocks are correlated you can run the risk of sticking to the 2% rule and still take a 10% hit if you have 5 positions open and they all gap against you*. This is the tricky part to it. It will work fine for a while then one day you get hampered on a nasty move against you. 

Best way to avoid this if you need to hold a couple of positions is be careful not to fool yourself that you sticking to the 2% rule while you are holding for example 5 Gold plays. that is one trade and risking 10% on one trade 

Also you could scale into positions. for example 1 today. add another after a couple of days & the first is in profit. then another after the second is in profit etc.


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## professor_frink (16 April 2008)

Trembling Hand said:


> *As most stocks are correlated you can run the risk of sticking to the 2% rule and still take a 10% hit if you have 5 positions open and they all gap against you*.




One way to help mitigate this(apart from waiting for there to be some unrealised profit before entering new positions) is to reduce the % risk on the subsequent trades if they are being opened at the same time.

From there it's just a matter of time until murphy's law kicks in and you start seeing gaps only on the positions that are carrying the biggest % risk


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## im sparticus (16 April 2008)

I also like the max 35% of account held in margin in conjunction as the 2% per position rule for limiting amount of trades at any one time, would like to hear others opinions/improvements/faults on this rule?


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## Trembling Hand (16 April 2008)

im sparticus said:


> I also like the max 35% of account held in margin in conjunction as the 2% per position rule for limiting amount of trades at any one time, would like to hear others opinions/improvements/faults on this rule?




What relevance does the Margin to hold a position matter to anything? It has no relationship to risk per position does it?


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## im sparticus (16 April 2008)

Trembling Hand said:


> What relevance does the Margin to hold a position matter to anything? It has no relationship to risk per position does it?




20000k account, $400 per loss

spi 1 contract 6.25k margin 16pt stop or 2 contract 8pt stop 12.25k margin or 4 contract 4pt stop margin (hang on ive run out of money to fund the position) see the relationship.


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## im sparticus (16 April 2008)

Trembling Hand said:


> What relevance does the Margin to hold a position matter to anything? It has no relationship to risk per position does it?




if it had no relationship to risk they wouldnt charge it anyhow any reason why you dont think its a good way to manage the number of multiple open positions


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## Trembling Hand (16 April 2008)

im sparticus said:


> if it had no relationship to risk they wouldnt charge it




Really. CMC you can get 3% margin on BHP. Or 1% on an index. That has absolutely no relationship to the risk of holding these things.


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## Kauri (16 April 2008)

You may only be risking 2% per trade but unless you are runningGSL then your risk is really only indicative... overnight gaps can do a lot of damage... only using 35% is a way of avoiding potential ruin??
Cheers
..........Kauri


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## Trembling Hand (16 April 2008)

Kauri said:


> only using 35% is a way of avoiding potential ruin??




What if you have 6 CFD trades that take up 35% of margin each gap down 4% taking out 30% of your account in one hit. It is not ruin but its probably the first step. Margin required is no indication of your risk.


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## Trembling Hand (16 April 2008)

Kauri said:


> ... overnight gaps can do a lot of damage...




You don't mean a stop would be set @ 2% of the stock price do you?


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## im sparticus (16 April 2008)

Trembling Hand said:


> Really. CMC you can get 3% margin on BHP. Or 1% on an index. That has absolutely no relationship to the risk of holding these things.




index1%-bhp3% you still cant see the relationship??

but i do get your point (i trade cfds with maquarie and never knew margins could be so loose) do you think the 35% rule would be sucsessful with realistic margin requirements from real providers. ie 5% for the spi and say 10% for a bluechip etc.


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## Trembling Hand (16 April 2008)

im sparticus said:


> but i do get your point (i trade cfds with maquarie and never knew margins could be so loose) do you think the 35% rule would be successful with realistic margin requirements from real providers. ie 5% for the spi and say 10% for a bluechip etc.




I think it can only be calculated by the actual movements of the instrument. I would worry about realistic stops rather than margin.


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## Kauri (16 April 2008)

Trembling Hand said:


> What if you have 6 CFD trades that take up 35% of margin each gap down 4% taking out 30% of your account in one hit. It is not ruin but its probably the first step. Margin required is no indication of your risk.




If you have 100% of your available account utilized and Bin Laden decides to fly into London bypassing Heathrow where are you??? 



Trembling Hand said:


> You don't mean a stop would be set @ 2% of the stock price do you?




No, surely _you_ don't??  

........Kauri


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## Trembling Hand (16 April 2008)

Kauri said:


> If you have 100% of your available account utilized and Bin Laden decides to fly into London bypassing Heathrow where are you???
> No, surely _you_ don't??
> 
> ........Kauri




LOL. Ok we are on the same page. Sorry. Time for a another


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## im sparticus (16 April 2008)

Trembling Hand said:


> I think it can only be calculated by the actual movements of the instrument. I would worry about realistic stops rather than margin.




ok so how do i calculate the movement of the instrament to arrive a a figure that will limit the number of my open positions and correlation between those open positions?


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## Trembling Hand (16 April 2008)

im sparticus said:


> ok so how do i calculate the movement of the instrament to arrive a a figure that will limit the number of my open positions and correlation between those open positions?




That is a lot harder than the 2% account risk per trade calculation. I would think a system trader could probably come up with some calculation but I guess it requires some common sense and feeling for the market.

As a rule I have a daily stop and weekly stop that I trade well within because I never want to be taken out of the action. If you set something like a weekly or monthly stop and trade so you are always within safe distance that will help to keep you safe.


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## tech/a (16 April 2008)

im sparticus said:


> ok so how do i calculate the movement of the instrament to arrive a a figure that will limit the number of my open positions and correlation between those open positions?




Your talking Portfolio heat.

This is how I use margin.

Risk $1000(2% of account size) on say a $15 stock
My stop is 20c

Lets say I trade normally 10 stocks at the one time.
Allocation $20K each.

To buy 5000 of my $15 stock I need to use $75k or use leverage.
Same risk but can make the trade.


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## im sparticus (16 April 2008)

tech do you have any opinions on the 35% margin to equity ratio (adaptive analysis) in managing the number of open positions or total exposure?


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## Nick Radge (16 April 2008)

Great topic TH and one that many just don't grasp. There are a few of these key issues that should be grasped before people start trading, but they're for another day.

The level of exposure to the market is important if one is trading highly correlated instruments and one has many open positions in one direction. TH may not get into this scenario trading intra day in the Hang Seng and SPI, but a CFD trader may well do so.

In the professional funds management business, as a rule of thumb, a margin to equity ratio of 30% is a level at which leverage starts to be seen to be excessive. Now that's for exposure in one direction and its a conservative estimate.

For retail traders such as us we can take that higher, say 50% or so.

However. when one 'balances' their book, that is, holds a balance of longs and shorts then this level can be taken higher.

As an example I currently have 16 open positions across ASX and US equities, but I have 8 longs and 8 shorts. My margin to equity ratio is high, although not extreme, but I am comfortable in knowing that any major market move will more or less see my account be hedged.

Without a significant market move each positions does its own thing within its own trend which is the idea but I will be relatively protected in a collapse as Kauri points out.

The problem with having a balanced book is that its hard to achieve trading the ASX and secondly all position on the ASX tend to move in tandem, unlike the US. 


_This post may contain advice that has been prepared by Reef Capital Coaching ABN 24 092 309 978 (“RCC”) and is general advice and does not take account of your objectives, financial situation or needs. Before acting on this general advice you should therefore consider the appropriateness of the advice having regard to your situation. We recommend you obtain financial, legal and taxation advice before making any financial investment decision.

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## im sparticus (16 April 2008)

Thanks for the reply nick,

So basically if i give my shorts a negative number and my longs a positive as long as my total doesnt exeed 30% (or -30% if im heavier on the short side) im still within the boundary?

Also TH braught up a good point of different providers offering different margin requirements (some as low as 1%) how would this affect the 30% are there round figures on margin requirements we should stick to ie 5% for an index and 10% for a top 20 and ignore how much our provider is "actually" holding as margin?


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## Nick Radge (16 April 2008)

Personally I don't look at the margin/equity ratio and I never look at the individual margin. Common sense says that too many positions in one direction will hurt you eventually.

Don't read too far into this stuff. Just understand the common sense approach. If you're carrying 10 long positions and the Dow tanks 500 you're going to feel it.


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## im sparticus (17 April 2008)

Anyone ever thaught of using the "kelly criterion" for working out the amount to place at risk, sound like very agressive position sizing method but apparently its the best mathematicly proven way to get max return from your investment when playing a game where you have a positive expectancy, apparently using the method its impossible to do your account though it does add for a bumpy ride might work well with a gsl(obviously you will still bust without a gsl if the price gaps beyond your max amount at risk)?? any thaughts.


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## im sparticus (17 April 2008)

Trembling Hand said:


> you can play with this excel sim
> 
> Put in 6% risk per trade and run the sim 5 times. You will blow up on my testing 2 out of 5 trials even with a positive expectancy.





this is mathematically impossible as everything is infinetly divisible even with a 100% negative expectancy!


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## tech/a (17 April 2008)

You may wish to download and play with this matrix.

http://www.artoftrading.com.au/tools/DownloadView.asp?iddownload=44&idCategory=5&topcategory=5


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## im sparticus (17 April 2008)

any thaughts on kellys or half kellys criterion tech? i know its very popular with blackjack card counters for money managment and there whole strategy is exploiting a very tight edge (around 1%) just though money managment (there play remains mostly unchanged with changes in position sizing once the edge presents itself accounting for 70-90% of the profits) imagine what it could do for someone with the sorts of positive expectancys people around here quote. (kellys criterion allows them to put up alot more % wise than that matrix would have you believe would send you bust per trade)


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## tech/a (17 April 2008)

Had to look it up myself!

http://en.wikipedia.org/wiki/Kelly_criterion

But would be highly correlated to strings of losses.

While it has the advantage of maximising gain it has the drawback of deminishing the capital base in large chunks.

Personally I look at R/R and if I can maximise Reward to Risk then Compounding and Leverage will maximise my return---based upon R/R alone.

There are ways of adapting a less aggressive strategy and then ofcourse we would have to be specific on each trade relative to the results of all trades current and still open.

If we are only taking closed trades as the base "f" then it is simpler.
If portfolio value then this will vary.
Ive never used it and would suit someone who has a very defined trading system with a very clear blueprint.

The sort of discipline/Model to be able to practically deploy this form of capital maximisation would be rarely found outside Instos,I would suggest.


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## glenn_r (17 April 2008)

A report on a ASX50 system using OT's portfolio simulator, it is set at defaults and is just for illustration purposes only.





The Fixed Trade Size allocation method always attempts to trade a fixed number of shares.

The Fixed Dollar Amount allocation method always attempts to trade a fixed dollar amount per each trade

The Percent of Equity allocation method always attempts to trade a fixed percentage of the account’s current equity. As equity rises, the amount invested per trade also goes up in proportion to the equity amount

The Size to Equity allocation method begins by trading with a fixed trade size in shares or contracts. A series of equity levels defined by the parameters trigger allocation changes as they are crossed. Trade size will increase and/or decrease based on when the gains or losses of the Trigger Amount are realized.

The Kelly Criteria allocation method attempts to find the optimal allocation size (as a percentage of equity) based on J. L. Kelly’s famous formula. The new portfolio simulator implements this calculation on a bar by bar basis, allowing position size to be calculated without hindsight.
Parameters
Initial Amount—Specifies initial allocation amount in dollars. This amount is only used during the warm-up period, while the Kelly Formula calculation is warming up.

Warmup Trades—Specifies the number of trades which must complete before the Kelly Criterion is applied to the trades.

Multiplier—Specifies the multiple of the Kelly allocation which is used for the actual position sizing in the simulation. This allows users to replicate popular techniques such as ‘Half Kelly’. 

The Optimal f allocation method attempts to maximize equity growth. The method first finds the optimal allocation (as a fixed percentage of equity) based on all the trades in the simulation. The method will then apply the optimal fixed fraction to the complete series of trades.


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## tech/a (17 April 2008)

Yes I can see myself placing an average trade size of $3.8 million.
Plus a 72% drawdown.

Nice in theory!


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## glenn_r (17 April 2008)

The test was set @ 10% margin if your wondering about the big figures.


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## Trembling Hand (17 April 2008)

glenn_r said:


> The test was set @ 10% margin if your wondering about the big figures.




10 % of what??


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## Nick Radge (17 April 2008)

I'm well versed in Kelly %. One can get quite creative with position sizing but the bottom line however remains the same; the more you bet, the more volatile your account will become.


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## glenn_r (20 April 2008)

Trembling Hand said:


> 10 % of what??




Sorry been away at a work seminar at Glenelg, 10% margin means you only need $10 of your own money to trade $100 of CFD's, Equities etc.

So when you set 10% margin as a parameter in a back test it will magnify the returns and losses of your capital x 10.


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## Trembling Hand (20 April 2008)

glenn_r said:


> Sorry been away at a work seminar at Glenelg, 10% margin means you only need $10 of your own money to trade $100 of CFD's, Equities etc.
> 
> So when you set 10% margin as a parameter in a back test it will magnify the returns and losses of your capital x 10.




So its complete rubbish as far as sensible MM


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## glenn_r (20 April 2008)

Trembling Hand said:


> So its complete rubbish as far as sensible MM





I was just illustrating different position size techniques nothing more or less, personally I use % of equity.


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## doogie_goes_off (20 April 2008)

Glenn r, I am not a trader, I just came up with my own optimum rules, don't you think it's going overboard to find a formula for the optimum trade size/value rather than just finding out what works for you, particularly based on your income (if that's how you fund it?).


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## WaySolid (20 April 2008)

One parameter study I pay attention to is %fixed fractional risk vs Maximum DD on monte carlo runs of existing trades, add a fudge factor to the max allowed drawdown you will tolerate, find your allowed %risk and position size accordingly.

It's as much art and experience as math; as the data series you are working with as a trader is nonstationary and hopefully continuing to get better with some rough patches thrown in.

I can't imagine risking 2% of capital per bet, If you run the Max DD v FF% parameter study and have a look at what type of DD's you need to tolerate then that might give you a heads up, and you can assume reasonably safely that an out of sample draw down will prove to be your largest ever.


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## Nick Radge (21 April 2008)

You can actually calculate your maximum risk per trade based upon your drawdown tolerance.

As an example, if your trading win rate is 50% and your maximum drawdown tolerance is 25%, then your maximum risk per trade to remain within that tolerance is 1.78%.


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## alwaysLearning (26 April 2008)

Trembling Hand said:


> The oldest mistake in the game is the position sizing rule. From discussions in other threads about the dangers of leverage it is clear that people think because they(CFDs Futures etc) give you huge leverage that means you can take on large trading size. This is wrong.
> 
> If you take the simple rule as risking no more than 2% of your account on any one trade it simply doesn't matter what you use to trade you will always purchase the same amount of shares if you are using CFDs, Margin loan or direct share purchase. THIS IS VERY IMPORTANT. IN FACT THIS IS THE MOST IMPORTANT THING TO TRADING.
> 
> ...




In my brief study of foreign exchange trading, a lot of the users who were experienced said to not to spend more than 2% per buy either. That's interesting for me to see the same rule applied to shares.

Anyway I'm a shares newbie so I don't know much yet


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## Trembling Hand (27 April 2008)

alwaysLearning said:


> In my brief study of foreign exchange trading, a lot of the users who were experienced said to not to spend more than 2% per buy either. That's interesting for me to see the same rule applied to shares.




That is the fundamental point. It doesn't matter what you trade Futures, Forex, Stocks, options or probably horses. Don't risk more than 2% as a stop.


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