Saturday, March 17, 2012

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How to Decide How Much to Bet on a Trade?

There are multiple ways to decide depending on your trading style. But the key idea behind the right decision is to get comfortable with thinking of having lost the money the moment a position is opened in a stock. Investors and gamblers should assume that entire money is lost while traders should assume a percentage that they are giving as wiggle room for stop losses.

Most often traders aren’t comfortable with this kind of thinking. They keep thinking that the CMP determines their current capital value. One should get over this and think that one has already lost the money invested and whatever is at current price is their bonus.

For Investors and Gamblers

If you are looking at your stock market operation as a gambling bet or an investment like Warren Buffet does, you should be ready to lose the entire capital invested into the stock. This is a no-brainer. You should only bet that much amount that you are ready to lose and more importantly the amount that you feel comfortable to assume to have been lost already the moment you open your position in the stock. Don’t get into mood swings after you enter the stock. If you did, the amount was higher than your comfortable level. It is apparently common to experience mood swings when your money is on the table even for the least amount invested, but you can discipline enough to overcome this.

For Active Traders

Stock traders, who take advantage of the liquidity and flexibility, to switch stocks, that the exchange provides, should decide based on wiggle room they give for a stock before one exits a position to stop losses. This can be in absolute number or relative number.

Those, who fix the absolute loss per trade, should have an upper floor for the total capital, just to avoid doubling the absolute loss in the event of knee-jerk reaction. But the price point by which one exits the holdings to limit losses should where one's fixed loss amount is reached. I don’t understand why anyone would comfortably follow this. May be in US, it is common to calculate in dollar terms.

My Practice

Those, who fix percentage loss per trade, should decide that amount of which one is willing to lose 10%. I used to follow this one. For a given position, I used to decide the percentage loss based on the volatility of the stock (or beta value). For example you can compare VikasGlobalOne with WelspunCorp. The former has more beta than the latter. So you may decide 10% stop loss for the first and 5% for the last. Or may 4% and 2% respectively, depending on how active your trading style is.

If the percentage loss you decided is 10, then you multiply the amount that you are okay to lose by 10x and use that much. If you are very alert during the day and can check & exit the position at any time of the day, you can reduce the percentage loss (or wiggle room) and bet even more capital. After all, more active traders expect more gains and more gains come with more capital but with fixed loss per trade.

Consider it Lost

In all of the scenarios, the loss is only to account for the unexpected outcome. But the trader should master the skill of assuming the loss is made the moment the position is opened. This way there won’t be any mood swings no matter where the price trades. Exception would very rare days when stocks make deep knee-jerk reactions. But such days are followed by sympathy rallies for which one should plan to take advantage of.

Also this per trade loss is important practice. If you do pyramiding, then your total loss is a variable. In such case you should apply probability and find out how many trades will be profitable out of how many total trades. Then calculate and distribute the loss back to individual trade. This requires even more discipline as trader should think beyond one trade. More often traders get stuck or get distracted in the middle of few trades. Probability best applies for multiple samples, the more the samples the better. But it also requires pattern recognition skills to first determine probabilities out of volumes of historical data and add seasonal trends (which are like conditional probabilities) on top of that. Pyramiding is altogether a different but most exciting stock trading operation. But it is the surefire way to make biggest gains in a short time, though it is also difficult to decide the capital to bet.

Now that the 2008 recession has changed the way the world thought about investments, one should not decide the amount to loss in stock market to be equal to the amount one is okay to lose in life (combining all losses from all ventures). It should be less than that. Atmost 50%.

Any other way of deciding the amount of investment may lead to under-trading or over-trading. Under-trading is a waste of time as you won’t feel the gravity of the game with lesser capital and on the other hand over-trading leads to financial hell! Atleast be ready to like either consequence if you are a random operator and then move on without whining.

How do you decide how much to bet on a trade?

Old and Gold

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