The Hindu Business Line : Optimal trade size lowers risk

A typical trading plan defines the entry price, the price objective and the stop-loss levels. Such a plan does not always define the trade size. This article suggests that an optimal trade size is essential to improve trading efficiency. It also shows how to define the optimal trade size based on the capital-at-risk rule.

B. Venkatesh

While structuring a Core-Satellite portfolio for a certain client, an interesting question came up: How should a trader construct her portfolio for optimal gains? The answer to this question is important for successful trading.

This article addresses two rules that are essential to the trading process. One, the trader should have an optimal trade size to manage the portfolio risk. And two, the trader should engage in continual learning process to better her trading performance.

Trading Plan

Suppose the trader has Rs 10 lakh capital and wants to have not more than 10 stocks in the core portfolio and five stocks in the trading portfolio. The first step is to identify the stocks to build the portfolio.

If the trader fancies Markowitz Mean-Variance approach, she would have to run correlations among stocks. This is done to check which stocks combine well to bring down the overall portfolio risk for the same expected return or increase the expected return for the same level of risk.

Often, traders pick stocks based on the expected return without any regard to the Markowitz diversification principle. It is then prudent to have sector caps, so that the portfolio is not biased towards a sector without reason. Having selected the stocks, it is important to decide the trade size (the number of shares to buy), the entry price, and the price objective.

Trade size

Suppose the trader decides to buy Ranbaxy Labs if it closes above Rs 502. Her price objective is Rs 565 and the stop-loss is Rs 460. The trade size is based on the stop-loss level.

We will assume that the trader does not want more than 2 per cent capital-at-risk on a stock. The trader can overweight or underweight a stock based on her risk-return preferences.

Now, Ranbaxy Labs will have Rs 42 per share as the capital-at-risk. This is the loss that the trade will be exposed to if the buy order is filled at Rs 502 and the stock declines to Rs 460.

The maximum capital-at-risk for Ranbaxy can be only Rs 20,000, which is 2 per cent of Rs 10 lakh. So, the portfolio can accommodate only 475 shares of Ranbaxy Labs (20000/42). Some traders allow for price slippages while filling the buy and sell-stop order. They may, hence, take exposure to not more than 400 shares.

Portfolio construction

Traders typically have a price range for buying stocks that constitute their core portfolio. Suppose our trader decides to buy ITC for her core portfolio. She may set a price range of Rs 230-200 to “accumulate” the stock.

Based on trade-size rule, the trader can buy 450 shares between Rs 230 and Rs 200. She will first buy 100 shares at the current price of Rs 225. This token exposure gives a reason for the trader to observe the stock price movement for further accumulation. It is important to note the difference between accumulation and downside averaging. Suppose the trader buys 450 shares at an average price of Rs 215 and the stock then declines to Rs 190. Buying more shares at Rs 190 from the capital not allocated for this stock is downside averaging. That is not an optimal strategy.

The trader normally has certain stocks in the Watch List. If the portfolio already has the target number of stocks, the trader will have to first take profits on a stock before buying one from her Watch List.

Managing losses

It is often said that the trader has to primarily manage losses in her portfolio, for the profitable trades can always take care of themselves. The sell-stops are the risk management rules that the trader employs to manage her losses.

Emotions typically drive trading behaviour. So, it is not always that a trader takes losses when a stock hits the sell-stop level. Even professional traders suffer from loss aversion. And that decision can cost a trader, especially, if the stock sinks further.

One way to circumvent this emotional trading behaviour is to mark the sell-stop levels for each position and give it to the dealer at the brokerage office. The instruction to the dealer would be to simply execute the trades if the stock closes below the sell-stop. Taking losses will be initially difficult but the discipline will payoff in the long run.

Improving trading efficiency

Trading efficiency can be improved from learning, which is a function of two factors.

One, keeping a journal of one’s own trading process and clinically reviewing the mistakes committed.

And two, attending seminars, reading books and journals ranging from neurophysiology to technical analysis and discussing with trading coaches and mentors on how to continually improve the trading process. It is structured learning and using this knowledge that will lead to optimal gains.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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