Position sizing and risk management. The 2% rule and 6% rule

Research
1

Recently I was reading through Alexander Elder’s book “Entries and Exits”, and it specified the 2% rule and 6% rule of risk management.

I’ve attached an image of the rules for you to read.

I use the 2% rule in real trading. It has been working very well.

To use this strategy, the entry price and stop-exit price must be chosen before placing the entry order. The initial stop-exit price can be calculated any way you want, e.g. 10% drop from entry price, or ATR based.

After a position is opened, over time as price increases, the stop-exit level must be moved up. When the stop-exit level reaches above the entry price then the amount risked for this position becomes 0. i.e. you are above the break-even point for this trade. This trade will either make money or nothing, but will not result in a loss. (Except if it gaps down, but that can’t be prevented).

The stop-exit level should never be moved lower. The worst case scenario is if the price doesn’t really move up and just heads down over time and the position gets stopped out - you lose a maximum of 2% of the capital you had when you opened the position. Losing only a small amount on any losing trade helps to minimise account drawdown, especially when there are consecutive losses (e.g. a bad day in the market).

I plan on using the 6% rule soon. I didn’t find the explanation clear enough, but after some time thinking I have an understanding of it. It needs a bit of initial spreadsheet setup work and daily recording to determine how much risk is exposed on a portfolio basis. This may be useful when the greater market goes through some turbulence.

It would be good to be able to simulate these position sizing/risk management strategies in Portfolio123.

There is a related feature request discussion here:
http://www.portfolio123.com/mvnforum/viewthread?thread=2411

Alexander Elder.Entries And Exits.2% 6% rule.jpg
Alexander Elder.Entries And Exits.2% 6% rule.jpg650×592 70.7 KB

2

I can’t comment on the 6% rule since I don’t see how it pertains to a portfolio of stocks for which you want maximum amount of capital invested. (Perhaps I don’t understand the rule).

For the 2% rule I have some issues. First is that we can’t simulate true stops in in P123. Second is that the rule is too idealistic. It assumes you can get out at your stop price. In reality this is often not true. Many small/micro cap stocks can go down 20-30% overnight before you have a chance to sell.

Steve

3

I thought the same thing when I first read the 6% rule. As I said, it doesn’t explain it very well. But I spent some more time thinking about it and I was wrong.

Let’s try an example.

Initial account equity = 100,000

Day 1:
Position 1 opened with risk of losing 2,000
Position 2 opened with risk of losing 2,000
Position 3 opened with risk of losing 2,000

Total risk of loss is 6% of account equity. So no more positions can be opened today.

A few days later:
Stock price of Position 1 has risen, so stop-exit level is raised.
Stock price of Position 2 has risen, so stop-exit level is raised.

Position 1 now has risk of losing 1,000
Position 2 now has risk of losing 1,000
Position 3 opened with risk of losing 2,000

Account equity = 105,000

Total risk of loss is a bit under 4% of account equity.
So this leaves room for one more position to be opened at this point in time (assuming the new position will risk losing 2% of account equity).

So basically the rule limits you from opening too many new positions at one time. Otherwise if they all get stopped out on a bad day it will make a large dent to your account. By allowing existing positions to increase in value before entering new positions, the dent will be softened by the profit you’ve already made from those older positions.

I’m still trying to understand it more and I think I will get it once I actually create my spreadsheet to manage it.

That doesn’t mean you can’t use stops in real trading. Portfolio123 needs to implement this feature. Stops are essential, especially in active short-term trading. I never close positions at next open.

You can say the same thing about any other exit strategy/sell rule. So why bother having any kind of exit strategy at all? Is Portfolio123’s exit at next open any better at handling the 20-30% overnight moves?

You may be missing the point. Think about the principle behind it. The point of this particular strategy is to have some control over losses. How many consecutive losses can you go through before you get a 50% drawdown?

Using the 2% rule, it would take over 30 consecutive losses to get a 50% drawdown; 14 consecutive losses to get a 25% drawdown; 5 consecutive losses to get a 10% drawdown.

I am fully aware that this is all just theory, and that there are other real-life factors involved such as slippage and gaps that can influence real results. But that doesn’t mean that this is all rubbish and not worth thinking about. The theory can still be applied, and even though it may not work perfectly well, it may produce some positive results.

4

hyper - you are hurting my brain :slight_smile:

Steve

5

The main problem I see with the 6% rule is that you would be missing out on opportunities.

Maybe I would only use the 6% rule when I feel that the market is a bit shaky. It’s still a good idea to keep track of how much your total portfolio risks losing in the case that all positions are stopped out.

6

In Tradesim there is a term called “portfolio heat”. It’s similar but not the same as the 6% rule.

Here is the section in Tradesim that explains percent-risk based position sizing and portfolio heat.

You can get the full Tradesim user manual here:
http://www.compuvision.com.au/Downloads/UserManual.zip

7

Hyper:

I studied Elder’s books and I have come to the conclusion that the 6% rule makes a lot of sense for trading futures, but it make no sense for trading a diversified portfolio of stocks without margin.

The reason is futures are highly leveraged and often highly concentrated in just 2 to 4 commodities. If risk is not carefully managed, a futures account can quickly drop to zero. A stock account will never drop to zero unless one is investing in just 1, 2 or 3 stocks or unless one is using margin or short selling.

If I am using 4 different long stock strategies each of which has 10 different stocks, then there is only 2.5% in any given stock. Even if 3 stocks go bankrupt on the same day (very unlikely), the loss would only be 7.5% which would be easily survivable for me.

Of course, each of us has different risk tolerances, so 7.5% might be too much for some.

If I were trading futures, I would be using the 6% rule or some variation of it.

Regards.

8

Elder sells a program to manage your positions and calculate your risk exposure based upon the 2%/6% rules. I don’t use the software so I can’t comment on it.

http://shop.elder.com/shopexd.asp?id=226

I read his books a few years ago and started implementing the 2%/6% rules. Even though my trading portfolio is not usually fully invested my trading returns have improved dramatically because I am able to eliminate the big losses to the portfolio with better risk management. My equity curve has smoothed out nicely as well.

9

a large consecutive string of losses will have a much smaller effect when you have 40 simultaneous open positions as opposed to having 10 to 15 simultaneous positions. Though I think having 10 to 15 positions in a single portfolio is a much more common way of trading than 40 positions across 4 different portfolios, and these rules would be more relevant to those who trade that way.

Note though that the 6% rule can still be applied regardless of how many simultaneous positions you plan to have. It prevents you from opening too many new positions at once, and instead promotes building the portfolio gradually. This would be especially beneficial during tough times in the market. Entering 40 new positions at once and then experiencing a massive market drop just a few days later would hurt a lot.

If 6% is too small then you can change the number to whatever you feel is right for you. It’s the principle behind it that is the point.

10

I had heard of the 2% rule (and more generally, the importance of keeping losses small) quite often in my earlier days but never took it seriously enough. I was trading CFDs, which had 10:1 leverage. I was holding 10,000 dollar positions with wide stops, like 20% from entry. I made large gains when the market rose, but when the market turned bad I ended up with over 50% drawdown in my account.

Now I trade using 4:1 leverage with interactivebrokers.com, and I use a spreadsheet to do my position sizing. This spreadsheet has become an essential tool to me that I can’t do without.

I’ve also realised from thinking about how to use the 2% rule together with leverage, that leverage should not be used to hold larger positions, but to hold more positions. Tie this with the 6% rule and you’ve got a way of trading that has a high degree of capital preservation.

Without good capital preservation, you can end up quickly giving back big chunks of your gains or more when things turn bad.

11

Smart money management is truly the key to being a successful trader. I actually experimented once with live trading using a completely random entry and the 2%/6% money management rules. I cut losers short very quickly (-2%) and let winners run with a tight (4%) trailing stop. Over around six months I was up about 5% on the trading portfolio in a sideways market.

12

I personally am not a believer in stops. Apart from the potentially high slippage when dealing with smallcaps, there are also market makers targeting and taking out the stops.

Also, you may preserve your capital initially. But how do you know when to get back in? You can get back in and be stopped out again and so forth. I have been developing trading systems for approx. 15 years and what I have found is that when you use stops for money management you will theoretically prevent an individual position from incurring a large drawdown but eventually you get many small losses adding up and your account drawdown is larger than if you didn’t place stops. I say theoretically because you really can’t guarantee anything with illiquid stocks.

Steve

13

I still think trading without stops is playing with fire. The key is to use the correct approach to stops for the stocks you are trading as one size does not fit all.

As Stittsville123 pointed out small caps obviously pose some challenges with their wide spreads and relatively low liquidity. If your stops are too tight you might stop out “too soon” and get whipsawed around if you keep trading that stock. I personally use around 20% for small caps. I’ve found through experience that if a position goes that negative against me it probably doesn’t come back, but giving it some “breathing room” often works out ok.

With large caps you can tighten the stop considerably since (usually) the volatility is lower. With large caps I use no more than a 10% stop.

I haven’t had the negative experience that Stittsville123 mentioned regarding many small losses eventually incurring a larger drawdown. My experience is quite the opposite actually… I don’t mind incurring many small losses if I can avoid the larger losses in the process. It’s the blowup loss that can kill the positive return of a portfolio over a long time. If I find myself getting whipped around with a position I just quit trading that stock and go find another one with better action. I guess it all just depends on your trading style and system.

I’ve seen some interesting ideas around using a stop based on the Avergage True Range (ATR) of a stock, though I haven’t incorporated that approach myself. I am interested to hear if any others have tried that approach and what their results have been.

14

Where I find the problem is simulations over long term. Generally I find that stops do not improve overall drawdown but do reduce profitability.

That being said, I tend to focus on falling knife type strategies as opposed to breakout strategies. Stops probably make sense with breakout strategies because the objective is to cut your losses short. As far as playing with fire, I trade a large number of stocks so the impact of any one stock falling off a cliff is minimal. So maybe I still fit into the 2% rule not using stops.

Steve

15

Steve,

As an engineer I know that you try to rely on the analysis to give you guidance for you trading methodologies. In my experience with P123 Sims, I have always been able to significantly improve a Sim’s annual return and reduce the max drawdown for Momentum Sims and/or Value Sims by using trailing stops correctly. So, I follow the Sims and use stops in my real trades.

However, with the Sims that I have developed that trade very short time (1 to 4 days), or Sims following the approach of the Steve’s Challenge or Olikea’s Challenge threads, I haven’t been able to significantly improve them with stops.

So, if you can improve your Trading Methods (Sims) with stops, then use them. Otherwise don’t. Follow the Sims!

Denny :sunglasses: