The 2% Rule and leverage

[Trembling Hand]

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.

 

[Trembling Hand]

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.

 

[ezyTrader]

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

 

[Trembling Hand]

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.

 

[professor_frink]

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

 

[im sparticus]

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?

 

[Trembling Hand]

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?

 

[im sparticus]

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.

 

[im sparticus]

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

 

[Trembling Hand]

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.

 

[Kauri]

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

 

[Trembling Hand]

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.

 

[Trembling Hand]

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

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

 

[im sparticus]

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.

 

[Trembling Hand]

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.

 

[Kauri]

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???

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

No, surely you don't??

........Kauri

 

[Trembling Hand]

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

 

[im sparticus]

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?

 

[Trembling Hand]

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.

 

[tech/a]

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.