Measuring Risk

A few of you have asked what I mean when I say that I made "4 times my risk" in my previous post. I'll try and explain:

For each trade I risk a dollar amount. It's different for every trade. So, for example, I buy KEX today (not a recommendation) at 54.84. I see that on average it hasn't lost (or gained) more than $2.24 in a day over the last 2 weeks. I decide that I will sell the stock if it varies more than 2 times that amount in a day (2.24 X 2 = 4.48). I am willing to lose $4.48 per share on KEX.

My portfolio is $100,000 (as an example--I really have billions). I decide to risk 1% of my portfolio on each trade--or $1,000. For KEX that means I can buy 223 shares ($1,000/$4.48).

If KEX goes $4.48 against me, I sell and I lose what I risked or $999.04 or 1 times my risk. If KEX gains $8.96 I make 2 times my risk. I keep track of each trade and record how much I risked.

At the end of the month, I add the winners and losers and come up with a risk number for the entire month.

Here's are my stats for April: I had 14 winners that totaled 9.55 times my risk and 11 losers that totaled 4.96 times my risk.

Calculating risk this way can help you get a feel for your system while allowing you to "plan" your earnings. So, I know that if I can average 4 times my risk each month and I risk $1,000 on each trade, I can earn $4,000 per month with my system (theoretically of course).

More on Expectancy

I asked my brilliant wife to help me work out some issues I was having with calculating information for the two screens I wrote about in the previous post. She insisted that I needed a measurement of risk for each trade. I insisted that I didn't. She was right.

So I went back and re-calculated the expectancy for each screen and edited the post with more accurate information. What I learned in trying to figure things out is that the expectancy of each screen will measure the average risk of a trading system. For example, the Zweig RS 5 screen's expectancy is .18. So, if you make 100 trades you should average about 18 times the risk that you took on each trade over those 100 trades. The system produced 244 trades over 2007, so if you risked 1% of your portfolio value on each trade you should expect about a 43.92% return over the year.

I went back and applied a 10% stop loss to all the losing trades to even out some of the larger losses that probably would have been avoided with a stop loss. I know that a few of the gainers would be stopped out as well, but I didn't take that into account. A 10% stop loss shoots the expectancy up to .79. Nice. That brings an expectation of a 193% yearly return risking 1% per trade on 244 trades.

Using expectancy and risk analysis allows you to make better decisions about your system and your stop losses, while allowing you a better way to compare systems. This is the first time since I started trading that I have analyzed things in this way and it has really helped me get a better handle on what I am doing. I think that I can get to the point where my emotions and feelings don't control my trading behavior. I no longer will need to labor over the placement of stops, or obsess over finding the "perfect" system.