Using Percentages to Allocate Risk

Using Percentages to Allocate Risk

A simple change in the way you calculate how much to risk per trade can change the direction of your trading. Most new/novice traders start out with a dollar amount they are willing to risk. “I’m going to risk $50 per trade” or “I’m going to risk $100 per trade”, then in the natural progression of their thought, they use the dollar amount as their stop-loss. This is amateur at best and lazy at worst, but it is normal and typical. Traders need to look at percentages of capital available to trade or percentage of “risk capital” rather than flat dollar amounts of risk. 

The trading and investing world always looks at percentages. Whether talking about how much a market is up or down in a given time period to how much of a given portfolio is allocated to a particular investment or sector. There is a reason for this. Working in percentages keeps the trader’s risk steady. Imagine a trader has a total of $2000 of risk capital allocated to short-term trading and decides to risk $100 per trade (which is 5% of $2000).

The result of the first trade is a loss. The remaining balance of invest-able capital is now $1900. If in trade number 2, our fictional trader again risks $100, it seems like the same amount of risk, but it is actually 5.26% of risk capital. Conversely, if the first trade is a gain then the new balance is $2100 and a $100 risk on the next trade is only 4.76% of risk capital. The result of this exercise is an increase in capital at risk during losing streaks and a decrease during winning streaks which is the exact opposite of what should be happening. Risk should be increase as money is made and decreased as money is lost.

If the same trader used percentage of capital, say 5%, instead of a flat dollar risk, notice what happens. In the same scenarios, the first trade results in a 5% loss, or $100, then in the second trade only $95 is placed at risk (5% of $1900 is $95).

If the first trade results in a 5% gain, then the next trade results in $105 being placed at risk, since 5% of $2100 is $105. This is the responsible, professional way of allocating risk and is much easier that increasing and reducing capital at risk at random times after building a cushion. Makes sure you do not risk more than you can afford to lose in any trading plan and use professional tactics to become a more successful trader.

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