this case, you’re willing to risk $2,000, and your risk per share is four points, so
you need to buy 500 shares to take on a total risk of $2,000 (2,000 / 4). Finally, if
the stock is priced at $100, the entire trade will tie up $50,000 of your capital (100
* 500). These calculations are essentially the same as those we just did in Chapter
24, when discussing the Kelly formula. More formally, the formulas can be stated
as follows:
ST (AC * f) / SL
and
MT ST * EP
Where:
ST Shares to trade
AC Available capital
fFraction of capital to risk
SL Stop loss, distance transformed to points from percentages between
the entry price and stop-loss level
MT Money tied up in trade
EP Entry price of stock
I’m being redundant here, but I want you to get a firm understanding of this,
and as the saying goes, repetition is the mother of all knowledge. On that note, I
once again would like to point out that the more you are willing to risk per share
and the lower the f, the less money you tie up in the trade. The trick, then, is to bal-
ance the fand the SL so that you can be in as many positions as you desire at the
same time. In the previous example, with the account balance at $100,000 and
with the trade tying up $50,000, you can only be in two similar positions at the
same time [Integer(100,000 / 50,000)].
However, if you lower the fto 1 percent and increase the SL to six points, a
single position will tie up $16,600 [100,000 * 0.01 / 6 * 100], and you can be in
six similar positions at the same time [Integer(100,000 / 16,600)]. The chore is to
find a trading strategy that makes it possible to be in the desired number of posi-
tions given your account equity. The difficulty is, however, that to increase the
number of possible positions to be in at any one time, the stop loss needs to be
placed further away from the entry price than what might make sense for a short-
term strategy.
In the last example, the stop loss was placed 6 percent away from the entry.
For a decent risk–reward relationship going into the trade, the profit potential,
therefore, needs to be at least 12 percent, for an initial risk–reward relationship
of 2:1. This isn’t all that realistic for a short-term trading strategy. We will learn
how to work around this dilemma soon, but first we need to back up to the for-302 PART 4 Money Management