Reader Question: Why Not Equalise Risk and Reward?
Nov 11, 2011 at 5:24 pm in Risk Management by
When running a previous Trading Trail public trading run one of my readers asked me why I didn’t equalise the risk on my various positions. The point is that, since I establish all positions at £1-per-point, a position in a 10p stock carries a £10 risk whereas a position in a 100p stock carries a £100 risk.
In the absence of any stop orders this would be true, but in practice I deploy wider stops on lower-priced stocks and tighter stops on higher-priced stocks (and potentially other financial instruments) so that risk is about £10 or 1% of my £1000 budget in all cases.
It would be more accurate to suggest that I’m not equalising the reward on all of my positions, because a 10p will generate a £10 profit if it doubles in price whereas a 100p stock will generate a £100 profit if it doubles. It’s a fair point, but I could argue that a lower-priced stock is more likely to double in value whereas a higher-priced stock will likely enjoy a smaller increase.
Top-Down or Bottom-Up?
What this really comes down to is whether you plan a portfolio in top-down fashion, or let it emerge or evolve in bottom-up fashion from a set of underlying simple rules.
If you had £50,000 to ‘invest’ you might decide a priori to establish 25 stock positions worth £2,000 each.
I can’t — and don’t want to — decide in advance how many positions my spread betting portfolio will hold, now or in the future, and I have no idea how long each position will last as some positions ‘stop out’ and some others come in to replace them… so I have no idea how many positions to distribute my risk (and reward) across. All I know is that ideally I don’t want to risk more than 1% of my budget on each position, and I will achieve this aim through whatever combination of stop distance and position size is appropriate at then time.
The Problems of Top-Down Position Sizing
Ideally I would establish a position in a higher-priced stock at a fraction of £1-per-point, perhaps at £0.10-per-point so as to equalise the risk / reward with my lower-priced holdings, but in my Capital Spreads account I can’t do this because £1-per-point is the minimum stake.
Alternatively I could go into lower-priced stocks at a higher £10-per-point, which would require a tighter stop order to bring my risk-per-trade down to 1% and which would eat into my trading capital at a faster rate than I am comfortable with.
The other problem is that in a dynamic rather than static (buy-and-hold) portfolio, the changing portfolio value would require me to periodically re-balance my position sizes merely so as to equalize the risk-rewards on existing positions with the risk-rewards on new positions.
I’m not a big fan of centralised top-down planning, and I think that from my underlying rules — always start at £1-per-point, and keep the risk to 1% of funds on each trade — something good will emerge.
Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.