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Thursday
Jul052012

Emini Futures | Defining Risk

(QQQ)(DIA)(SPY)(GLD)(SLV)

 

Defining Risk

Risk as defined by Investopedia :

“A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk. “

 A big question amongst traders and on our Daily Live Broadcast today -

"What % of my trading account is acceptable for risk on any given trade?"

The first question that needs to be answered is how much of your total assets are in your account? If you have 1% of your net worth in an account and you risk 10% of your account on the trade, you may not be risking very much.

Conservative text books will suggest 1-2%. For a new trader this is excellent advice. However, if you are working with a $5k account and can only risk 1% on the S&P 500 , that's $50 or 1 point. Here's the rub, most new traders do not posses the skill set required to trade successfully with only 1 point of risk. The true answer lies far beyond what you read in a book or hear in a seminar.

Let's look at an example - 

Perhaps your "setup" offers a 1:2 Risk/Reward scenario.

However, you are only "right" 40% of the time. This means 6 times out of 10 your trade is not profitable. Does this mean you should risk 1% or 10% or 20%?

You will never get the right answer by asking the wrong question.

In the above example we will consider trading 10 Emini contracts with a $10k account. Let's see what happens over 100 trades using a 2 point stop and 4 point target.

60 losing trades x $1,000 per trade = $60,000.00

40 winning trades X $2,000 per trade = $80,000.00

Total Profit before commission = $20k or a 100% ROI

To trade 10 contracts requires $5k intraday. That's an initial risk factor of 50%.

Position sizing on the other hand, allows you to control your risk through managing the size of each individual trade. Let’s look at another example:

You trade ten contracts on the S&P 500 E-mini futures with a stop loss of 2 points that's $100 per contract.

If your trade hits the stop then your loss before commissions is $1,000.

However, instead of getting in with 10 contracts at one time, you decide to put on 5 contracts with a 4 point stop. What would your loss be if that trade went against you?

Exactly the same.

Why would a trader want to trade with less contracts and more risk? The benefit is that you can get into a position with less risk on the table initially, let the trade develop, then determine if you want to place more risk on the trade by increasing the number of contracts. As you scale into a position, you could reduce or even completely eliminate the risk as the trade moves in your favor by bringing your stop to break-even or better. With this strategy, you are increasing your winning potential while reducing your stop size. In other words, you have increased your chance of winning, put more contracts on the trade, and reduced your risk all at the same time!

Be wary of the hard and fast "text book" solution. Every trader must assess their own risk tolerance. No matter how many years you spend trying to suss it out, the bottom line is this - Trading is Risky!  You can lose all of your money be it over 10 trades or a 100, if you do not have a proper business plan and a carefully crafted trading plan.

Special Invitation - Tune in tomorrow and we'll bring you on air if you have a Risk Management Plan you would like to share with our listeners. Jonathan and Robyn will both be back to continue the discussion.

 

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