Waverly Advisors uses a true equal risk approach to position sizing; the concept is that each trade represents a consistent risk to the portfolio, so a full sized loss in any market will result in the same percentage loss to the overall portfolio. In general, we find risks of 4% or greater to be very aggressive, while risks of 1% or less are extremely conservative. Most traders find risks in the 1.5% – 3% range to be ideal, but this is a decision that must be made based on your risk tolerance. One important thing to consider is the impact of a string of full sized losing trades. Though unusual, it is certainly possible to have, for instance, five losing trades in a row. At a 5% risk level this would result in a 22.6% drawdown. Our average losing trade does tend to be considerably smaller than the initial trade risk (due to moved stops and trade management), but the possibility of multiple full-sized losses must be fully embraced from a psychological and risk-management standpoint.
Once a risk level for all trades is set, it is important that all trades use this same risk level. Do not use more risk on “trades that look good” and less on trades that feel riskier. The one exception to this rule might be aggressive countertrend trades with significant gap risk. We typically trade these on smaller risk and will note this in the specific trade setup.
An example may help to clarify these concepts. Assume that you are trading a $100,000 account and wish to use a 2% risk level for each trade. Also assume that we are entering the S&P e-minis at 1,602 with a stop at 1,585. The question is, how many contracts should you buy to achieve this risk level?
- First, calculate the intended Dollar Risk on the trade as Account Size X Risk% = Dollar Risk. In this case, $100,000 * 2% = $2,000.
- Next, calculate the Per Contract Loss at the initial stop level as |Entry Price – Stop Price| X Point Size (for futures contracts). In this case, the point size for the S&P 500 is $50, so: |1,602 – 1,585| * $50 = $850. A move from the entry price to the stop level will result in a $850 loss per contract.
- Last, calculate Trading Size as Dollar Risk ÷ Per Contract Loss: $2,000 ÷ $850 = 2.35 contracts. We would usually round down, so buy 2 contracts to achieve this risk level.
If we list a target we take half the position off at that level. We suggest that orders at these target levels should be working as GTC limit orders, active in all sessions. For purposes of publishing, we always execute as previously described, but traders may wish to adjust; taking smaller profits is more aggressive because it leaves larger positions on. We are swing traders, essentially looking for one clean swing with minimal “give back” on positions, so we will often use tight stops on existing positions.