Risk Management: Position Sizing Using Percent Risk

This is the second method I am sharing on correctly sizing the position of each trade with proper risk management techniques. The first post was a volatility-based system which uses Average True Range as the key indicator.

In this post, we will explore position sizing using a method often called Percent Risk. Percent Risk is the acceptable decline in a market based on a percentage of the purchase price where you will set your stop loss price.

Percent Risk is a bit of an arbitrary strategy; markets can be very different from each other. We will look at some potential techniques you can use to apply Percent Risk appropriately.

At first blush, you might be inclined to use the exact same Percent Risk across the board for all asset classes by choosing a simple number. For example, you might say that you will sell any position if it declines 5 percent from your entry price.

However, this means that every position you enter will be the exact same size based on your equity. This doesn't make a lot of sense since a short-term treasury bond ETF is far less likely to decline 5 percent than an individual small cap stock.

Should a high risk position be the same size as a low risk position when they will have drastically different effects on your portfolio?

Using Annual Standard Deviation

If you're using Percent Risk as a position size measure across different asset classes, I would recommend looking at the long-term annual percent standard deviation of security you are considering.

You can easily find the standard deviation of most assets on Yahoo Finance, Morningstar, and most trading platforms. The single standard deviation is the percent range that covers more than two-thirds of the historical annual price movements.

Once you have the annual standard deviation, you will need to determine how you will use this figure in your portfolio given your backtesting.

If you want to be very cautious, you may use the annualized standard deviation number without any alteration. This will generally result in small positions. If you want to set tighter stops, you may use a fraction of the annualized standard deviation to set your stop price.

For example, the annualized standard deviation of the S&P 500 is 15 percent. When we buy a low cost ETF for the S&P 500 (IVV), we would set our Stop Price at 15 percent below the current price. If we wanted to use half of annual volatility, we could set the stop price at 7.5 percent below the current price.

Although they both are a measure of volatility, this differs distinctly from using average true range. Standard deviation is the long-term price movement while ATR is based on recent daily price movements.

Using Static Percent Risk

Within an asset class, it could work well to use static Percent Risk for every security within that asset class rather than obtaining the annual standard deviation of each security.

One reason for using a static percent risk might be a lack of data to calculate annualized standard deviation; another reason might be ease of calculation.

For example, let's say you have a trading account where you trade individual small cap stocks exclusively. We know many small cap stocks are volatile, we know their characteristics can change rapidly as they mature, and there are also many small cap stocks without a long track record of pricing.

To get around these issues, you may want to simply set a relatively wide stop on every small cap stock you enter and simply assume the stock is susceptible to large declines—erring on the side of caution while still giving yourself the opportunity to participate in the price movements of many small cap stocks.

For example, you may set an initial stop of 25 percent on every new trade you enter. This will allow you to manage your risk in a consistent manner, ensuring your individual positions are not too big while setting a firm exit point.

If you choose a static Percent Risk method, it is still a good choice to make sure your allowable loss is within reason for each asset. Low risk assets like bonds should have a tighter stop loss point than high risk assets like small cap stocks.

Steps to Calculate Your Position Size Using Percent Risk

These are the steps to identify all the components you need to complete a proper calculation of maximum position size using Percent Risk.

  1. (R) Determine the maximum amount of equity you are willing to lose for each trade. This should be based on your total account equity at the time you enter the trade. (New traders should risk less than 1 percent per trade.)
  2. (P) Identify the current price of the security. I do most of my trade entries near the end of the trading day as volume tends to be higher. If you do your calculations after hours, use the closing price of the security.
  3. (D) Identify the Percent Risk. The Percent Risk can be static or based on annualized standard deviation volatility. A static Percent Risk will be the same for all securities in the account. If you use annualized volatility, you can use the whole standard deviation, or a percentage of the standard deviation depending on your system.
  4. (S) Calculate the Stop Price. Your Stop Price needs to be manually calculated using your chosen Percent Risk (D) with this equation: P*(1-D) = S.

The calculation for Percent Risk maximum position size is as follows:

R/(P-S) = U (Total Number of Units)

U*P = Max Position

or, in a single, simplified calculation:

[R/(P-S)]*P = Max Position

Example

This example will be a position size using the Percent Risk method with the MSCI EAFE Index (EFA).

  1. (R) This investor has a $100,000 investing account. His risk per trade is 1 percent. (The maximum amount of money he wants to lose if this trade goes against him is 1 percent of $100,000.) Therefore R = $1,000.
  2. (P) The current price of this security is $68.68. Therefore P = $68.68.
  3. (D) The standard deviation of this security is 18.02 percent. Based on this trader's extensive backtest of his particular trading system, he will use half of the standard deviation as his Percent Risk. Therefore D = 0.0901.
  4. (S) The Stop Price of this security will be calculated based on the Percent Risk and current price: $68.68*(1-0.0901) is $62.49. Therefore S = $62.49.

R/(P-S) = U

Calculation for U: 1000/(68.68-62.49) = 161.55 units

U = 161

Calculation for Max Position: 161*$68.68 = $11,057.48

The maximum position size of EFA for this trader purchasing today will be $11,057.48, or 161 units of EFA.

The trader will enter a purchase order to buy 161 units at a limit price of $68.68 per unit. On this trade, he will allocate 11.06 percent of his account equity to EFA.

The initial stop loss price will be $62.49. If the price of EFA falls to less than $62.49 near the close of the trading day, he will sell the position.

Alternatively, the trader can set a Stop Limit Order and have the trade automatically executed if the price falls to this level.

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RM Portfolios Update: September 2018

Welcome to the September update for the different portfolios which I track here at The Rich Moose blog. And Happy Thanksgiving weekend to all you Canadian readers!

I use Canadian-listed ETFs where possible for the models I share to keep the tracking, purchasing, and selling easy for Canadian readers. However, because they are not available in Canada, I use U.S.-listed 3x Leveraged ETFs and track returns in U.S. dollars for some of the Leveraged Barbell Portfolios.

See the list of my favourite Canadian ETFs on this page.

Vanguard All-in-One Portfolio ETFs

These Vanguard ETFs hold multiple assets inside a single ETF. It's nearly a perfect solution for investors who want to buy just one ETF and hold it forever without worrying about re-balancing, tax trigger issues, and excessive costs. Read my post reviewing these products to get an idea of how they are designed.

While I personally believe there are better ways to invest when you have a larger investment account, these Vanguard Portfolio ETFs are great for newer investors, people who don't want to spend any time thinking about their investing process, and investors who want to minimize costs that would otherwise use a "robo" advisor or a similar, more expensive passive investment approach.

Here are the September monthly & year-to-date returns of these portfolio products (benchmark data).

Vanguard Growth ETF
September:  -0.79%
YTD:  +4.17%

Vanguard Balanced ETF
September:  -0.78%
YTD:  +3.03%

Vanguard Conservative ETF
September:  -0.77%
YTD:  +1.88%

The decision between choosing the Growth ETF, Balanced ETF, or Conservative ETF depends on your tolerance for risk and your investment time-line. The Growth ETF should have the highest returns and highest draw-downs over time while the Conservative ETF will show lower returns with more stability. The Balanced ETF is a middle-of-the-road option.

Time Averaged Dual Momentum Strategy

Dual Momentum is a strict, rules-based investing approach which uses an easy performance evaluation to decide your investment holding for each month.

Most months the holding will stay the same; trades occur around two times per year on average. By evaluating just once each month, you can eliminate the negative effects of market noise and spend very little time managing your investments.

I use a very similar version of Time Averaged Dual Momentum in my own personal portfolio. Looking at the history, I think Dual Momentum investors have a good opportunity to have market beating performance with lower drawdowns.

The Dual Momentum strategy—as tested by Gary Antonacci of Optimal Momentum—has shown fantastic results over complete market cycles. Read his website, book, and research papers to get a full understanding of how the strategy works.

See how my Time Averaged Dual Momentum portfolio would have performed compared to a buy-and-hold indexing portfolio over the past 5 decades by visiting the Portfolios page.

This month we are once again staying in U.S. stocks which have been very clearly outperforming the rest of the world.

YTD Performance:  +7.60%
Last month's performance:  -0.80%
Current recommendation:  XUU.TO

When determining our monthly position, we consider the past performance of just three eligible holdings: U.S. stocks, MSCI EAFE stocks, and Short-term Canadian bonds. The best performer based on specific criteria becomes the only holding for the next month.

Leveraged Barbell Portfolios

The Leveraged Portfolio strategy uses a unique mix of short-term bonds and leveraged stock ETFs to achieve growth while limiting downside risks. It's essentially a barbell strategy where all the risk and growth is contained in a small portion of the entire portfolio.

Although I add a trend factor into the analysis for my personal portfolio, the strategy I use in my non-registered account works very similar to this Leveraged Barbell Portfolio.

If you choose to implement the strategy, make sure you treat each account as a whole portfolio. Do not put bonds in one account and leveraged stock ETFs in another account!

Leveraged portfolios are re-balanced just once per year. For this reason, I will always track the Year-to-Date returns only.

Canadian-listed ETFs (2x Leverage Stock ETFs)

HSU.TO (50%) & XSB.TO (50%):  +8.03%
HSU.TO (30%) & XSB.TO (70%):  +5.01%

U.S.-listed ETFs (3x Leverage Stock ETFs)

UPRO (40%) & BSV (60%):  +9.09%
UPRO (30%) & BSV (70%):  +6.80%

These allocations are just a few examples of how Leveraged Portfolios can work. Leveraged ETFs amplify positive and negative returns so they should always be paired with low-risk assets to meet your personal risk tolerance. In a non-registered account, you may use margin debt to purchase your stock index ETF for somewhat better tracking.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.