How I determine risk, leverage and sizing in a trade.

Sizing is always dilemma for aspiring traders. How much to buy or sell and how to determine the risk, those are the question?

I get more questions about sizing, leverage and risk control than about any other subjects. I don’t have the answers for everyone — but I know how I go about making these decisions. Allow me to use a future market, an ETF and a stock to provide examples.

The markets are the December Hog futures ($HE_F), the Silver ETF ($SLV) and $AAPL.

$HE_F. First, the little piggies.

I am very bearish on the December Hog contract. The CFTC COT report from this past week shows that the commercials (who are usually right — eventually — in the agricultural markets) have an all-time record short position. The funds (the large speculator) have an all-time record long position. There is a show down about to happen.

The Hog market is presently set up exactly the way the Soybean market was set up in early September. The two markets have two things in common. First, both tried to poke out of the top of massive rectangles and failed. Second, the Soybean market had a huge commercial short interest. The Soybean market subsequently dropped $2.50, meeting the downside target of its rectangle. See the Soybean chart below.

Hogs are just starting the decline. I believe the Hog market could be a debacle. The charts below are a weekly graph showing the COT profile and the daily chart. It is important to remember that COT data is just another input in the analysis process. The commercials are not always right.

I shorted the Hog market at 89.05 with a risk to above the high at 91.475, or a risk of about 250 points or $1,000 per contract. My typical risk on a trade like this is about 70 basis points, or 7/10th of 1%. I never really keep track of the margin that I am using because I am always way undermargined.

So, on a $1 million account my risk should be limited to $7,000. Thus, my position size is seven contracts. My target is a minimum of 81.00. Thus, I am risking 250 points to make 800 points for a reward to risk ratio of 3.2 to 1.

But that is not the end of the story. I believe the rectangle will be completed by a downward breakout and a move to 71.00. I am willing to double up if the market breaks 80.00, risking about 250 points on the double up. If I double up I will move my stop on the existing position to somewhere around 84.00. Thus, my net risk in Hogs will never exceed 70 basis points.

IF (big IFs) Hogs break 80.00, and IF I double up, and IF the market runs to 71.00, I stand to make $75,600 against a maximum risk of $7,000. This is a possible reward to risk ratio of 10.8 to 1. These are the types of trades I love.

$SLV — finally, let’s look at the Silver ETF.

The daily chart constructed a 5-point symmetrical triangle bottom. The advance on October 25 above the mid point high at 31.96 confirmed the pattern.

In my approach to trading the low of the breakout day often becomes the basis for my protective stop. Thus, long SLV at about 32.02 gets protected at 30.44 for a risk of $1.58 per share.

Again, let’s take a risk of 70 basis points, or $7,000 against a $1 million account. This risk would afford a position of 4,443 shares, rounded up to 4,500 shares.

The target in SLV is 37.46. This represents a profit goal of  $5.44 per share or a reward to risk ratio of 3.44 to 1. If SLV hits the target, the profit will be $24,480.

Now, let me get into a matter many of you consider important, but that I never even consider. The cost of 4,500 shares at $32.02 is $144,090. This is not the amount being risked. In fact, because I trade on borrowed money equal to 90% margin, I never even keep track of the amount of capital tied up in margin because it is seldom more than 20%. I had to calculate the total capital that would be used in a cash transaction for this example.

If I traded a cash-only account (like a self-directed IRAS) this would become a hinderance to the number of stocks I could be in at any given time. Yet, whether in cash or margin, I calculate my entry and stop points the same. In the case of a margin account I can trade more shares and I am willing to lose more as a % of trading capital.

If I had a cash only account I would probably limit my stock/ETF trades to about 10 issues at any given time and risk somewhere around 30 or 40 basis points per trade. This would equal a position of about 2,600 or so shares of SLV using the same entry and exit points. My dollar tie-up would be about $83,000. Again, remember my risk wof loss ould not be the $83,000 tie up (8% of my account), but only $4,000, or 40 basis points.

$AAPL — a catch-the-falling knive trade inverted

I identified Apple as an island top. I am not in the trade because I do not trade island tops absent other technical confirmation. An island top is not the pitch I am looking for.

Had I shorted Apple, I would have been looking to short at the bottom end of the island, or around $408 — with a target of $355. The risk would have been to the top of the gap, or around $416. Thus, with a risk of $8 and a potential gain of $53, the reward to risk  is 6.6 to 1. However, it is a low probability trade with only about a 20% chance of working based on my experiences. Had I taken this trade I would have risked about 30 basis points, or $3,000 on a $1 million account. The math: $3,000 divided by a risk of $8 per share equals 375 shares.  A normal requirement of a short position is that a round lots need to be traded. So, let’s adjust the sizing to 400 shares. A risk of loss of $8 per share with a 400 share position equals $3,200, or 32 basis points. Of course there is always the chance a market will gap beyond my risk point.

I hope these examples help explain how I approach the concepts of risk, leverage and sizing. Please — no posts in the reply chain about Apple’s forward earnings per share. I could care less.

$SLV, $SI_F, $HE_F, $AAPL

 

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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