Determining leverage

[qwertyuiop1]

Ok - I'm relatively new to trading so I am tryng to learn as much as I can.

The more I learn, the more questions I seem to have.

Anyway - can someone please find fault with this strategy please.As I say - i'm relatively new to teh whole game so all advice is welcome.

Upon entry I use a 10% traiing stop-loss which is adjusted on a weekly basis
(Lets not get too bogged down in the pros and cons of the stop-loss).

I have up to have a max of 10 positions filled at any one time.

So that means,using no leverage, I risk 1% on each trade.

Howver - I am thinking that if i was to backtest the entry, I could calculate what I lose on average.
E.g. Lets say for arguments sake I lose 0 on 50% of trades, I lose 6% of the 10% on 25% of the trades and lets say I lose 3% of the 10% on the remaining 25% of the trades.
So - If they were the results, then I could say that on averahge I lose 3.33% points of the initial 10% on each trade.
So - to sum up,on average I would lose one third of my initial risk on each trade over the long run.

So - if I am prepared to lose 1% of equity on average on each trade, then I could in fact use 3 times leverage.
Or if i was prepared to gamble 2% on each trade themn I could use 6 times leverage.

Am i makeing sense here ?
DO othger people use a similar strategy?

Is there a flaw in this logic which i am missing?

 

[Rhody Trader]

You don't use your average loss to determine your risk level per trade. You use your absolute risk level because you have to protect against the much larger than average loss.

 

[qwertyuiop1]

You don't use your average loss to determine your risk level per trade. You use your absolute risk level because you have to protect against the much larger than average loss.

When you say absolute risk level what do you mean?
Teh max that can be lost an any one trade ?

As opposed to my method of getting teh average loss per trade given that it is a trailing stop-loss?

Surely to use something close to the average expected loss is reasonable no?

As in - just like you use expectancy for an entire system - can backtesting not also be used to determine your expectant average loss ?
And from there determine the leverage factor.

 

[Rhody Trader]

When you say absolute risk level what do you mean?
Teh max that can be lost an any one trade ?

That's exactly what I mean. Since an outsized loss can devastate your account, you should generally first make sure you don't trade so large that you risk something like that happening.

As opposed to my method of getting teh average loss per trade given that it is a trailing stop-loss?

Surely to use something close to the average expected loss is reasonable no?

As in - just like you use expectancy for an entire system - can backtesting not also be used to determine your expectant average loss ?
And from there determine the leverage factor.

You mentioned a 10% per position risk, accounting for a 1% per position exposure. If you trade at 3:1 and your initial stop gets hit that means you take a 3% loss. If you're at 6:1 that means a 6% loss. That's the issue at hand, especially if you suffer multiple losses in a row or in a relatively short period of time. Do you know how that would play out in your performance?

 

[qwertyuiop1]

You mentioned a 10% per position risk, accounting for a 1% per position exposure. If you trade at 3:1 and your initial stop gets hit that means you take a 3% loss. If you're at 6:1 that means a 6% loss. That's the issue at hand, especially if you suffer multiple losses in a row or in a relatively short period of time. Do you know how that would play out in your performance?

While i do see your point RhodyTrader in that when determioning how much you want to lose it should be worked off the max possible loss an any given trade.
However - with a trailing stop-loss do the rules not change somewhat?

As in - surely the expected average loss per trade should be considered as well as the max loss per trade?
Presumably there is some optimum number between those 2 figures that ideally would be used when trying to determine the leverage factor?
This would make sense to me.

Anyone else out there that uses a trailing stop loss and has subsequently backtested their system to calculate an average expected loss per trade?
And have you then used this figure as part of your entire system?

 

[Rhody Trader]

While i do see your point RhodyTrader in that when determioning how much you want to lose it should be worked off the max possible loss an any given trade.
However - with a trailing stop-loss do the rules not change somewhat?

The trailing stoploss is not reflective of the max loss you can suffer on a trade. As such, it is of secondary consideration in your initial position sizing.

What you really should do is some testing to see what your drawdowns look like under different leverage scenarios. They will encapsulate not only the max losses, but also the consequence of bad patches where you perhaps have the smaller losses, but in bunches.

 

[qwertyuiop1]

The trailing stoploss is not reflective of the max loss you can suffer on a trade. As such, it is of secondary consideration in your initial position sizing.

True. However I do think it is reflective of the expectant average loss per trade.
I don't think the expectant average loss per trade should be completely ignored.
That is useful information in my book and should be incorporated into a trading system for those people that use trailing stop-losses.

But ya - you are right in that i shoud back test it.

Must get me the software to do that.

 

[Gumping]

Good Question

I trade trailing stop-losses, so I'll tell you what I do, (which is neither right, nor wrong) which is exactly as Rhody stated above: I use the max. amount I can lose on a trade to define risk. Hence the max. amount would be my stop-loss level multiplied by leverage. True enough I've never been stopped out for a maximum loss, so my risk is possibly far lower - but ultimately, the level of risk has to be something that you are happy with - and these fairly conservative rules allow me to walk away from the screen once my trade is set and let the trailing stop-loss do it's thang - ie it minimizes fear.

That's my take on it anyway

 

[Chorlton]

Hello All,

IMO Defining ones risk in a trade has NOTHING to do with leveraging!! Leveraging allows one to take additional positions which would normally not be possible. Thats it!!

The risk involved should be worked out on the basis of your own capital ONLY and you should only risk a percentage of that amount.

Say you had $50,000 of your own capital and are willing to risk 1% as an example:

Buy Price = $1.00
Stop = $0.80
Amount risked = $0.20
Risk = 1%

$50,000 x 0.01 risk = $500 divided by amount risked ($0.20) = 2500 shares can be purchased at a cost of $2500 (ignoring comms, etc)


Chorlton

 

[Mathemagician]

I think it was Bill Eckhardt who did a study where he assumed perfect knowledge of the year-end closing price for the stock market at the beginning of each year. Even with this knowledge, he found it was counterproductive to use more than 3 to 1 leverage.

jj

 

[qwertyuiop1]

Hello All,

IMO Defining ones risk in a trade has NOTHING to do with leveraging!! Leveraging allows one to take additional positions which would normally not be possible. Thats it!!

The risk involved should be worked out on the basis of your own capital ONLY and you should only risk a percentage of that amount.

Say you had $50,000 of your own capital and are willing to risk 1% as an example:

Buy Price = $1.00
Stop = $0.80
Amount risked = $0.20
Risk = 1%

$50,000 x 0.01 risk = $500 divided by amount risked ($0.20) = 2500 shares can be purchased at a cost of $2500 (ignoring comms, etc)


Chorlton

Hi Chorlton,

Yes - I would agree with you to a point.
Hopwever - it does depend on your trading strategy.

Personally - I am a long term 'investor' as opposed to trader - (ALso applying some basic fundamental analysis)
i.e. I would hope to hold positions for months on end.
Therfore - short term support and resistance would not have as much of an impact for me.

So - for me I hold max 10 positions at any one time using a 10% stop-loss.(As opposed to using a stop-loss outside teh noise)
i.e. 1% risked per trade assuming no leverage.

Howver - If i do decide to risk,say,. 2% then that allows me to do 2xleverage.
And 3% allows me 3xleverage. etc.

So in that scenario I do think that defining ones risk has everything to do with teh amount of leverage used.

And that is why I am trying to find out that by if I can guess that I have an average expectancy loss of say, 6.66% of the initial 10% on each trade, thereofere I can actually take 3xleverage but still only risk 2% on each trade.
Or - if I can guess that I have an average expectancy loss of say, 3.33% of the initial 10% on each trade, thereofere I can actually take 6xleverage but still only risk 2% on each trade.


ANd that is what I am trying to establish here.

RhodyTrader thinks my logic is flawed and suggests I shoudl only look at teh max potential loss on anyone trade.
I beg to differ and think that average expectancuy loss should certainly have some influence on the risk per trade.
My quandry is I am trying to figure out how much infliuence it should have.

 

[Chorlton]

See comments below:

Hi Chorlton,

Yes - I would agree with you to a point.
Hopwever - it does depend on your trading strategy.

Sorry but I disagree. The use of "Leverage" (which I would define as "The amount that one utilises borrowed money" ) makes no difference to which strategy one employs. As I have said before "leverage is leverage". Thats it!!

Personally - I am a long term 'investor' as opposed to trader - (ALso applying some basic fundamental analysis)
i.e. I would hope to hold positions for months on end.
Therfore - short term support and resistance would not have as much of an impact for me.

So - for me I hold max 10 positions at any one time using a 10% stop-loss.(As opposed to using a stop-loss outside teh noise)

From my experiences the use of a % stop is one of the least effective choices IMO. Can I ask how you derived at it?

i.e. 1% risked per trade assuming no leverage.

Howver - If i do decide to risk,say,. 2% then that allows me to do 2xleverage.
And 3% allows me 3xleverage. etc.

If I understand you, on trades which you believe have a higher success rate (for whatever reason) you are willing to risk more? If this correct, then IMO this is not what I class as "leverage". If this is what you are trying to achieve, then there are other ways to do this such as pyramiding. If its not, then my apologies as I'm little confused.

So in that scenario I do think that defining ones risk has everything to do with teh amount of leverage used.

And that is why I am trying to find out that by if I can guess that I have an average expectancy loss of say, 6.66% of the initial 10% on each trade, thereofere I can actually take 3xleverage but still only risk 2% on each trade.
Or - if I can guess that I have an average expectancy loss of say, 3.33% of the initial 10% on each trade, thereofere I can actually take 6xleverage but still only risk 2% on each trade.


ANd that is what I am trying to establish here.

RhodyTrader thinks my logic is flawed and suggests I shoudl only look at teh max potential loss on anyone trade.
I beg to differ and think that average expectancuy loss should certainly have some influence on the risk per trade.
My quandry is I am trying to figure out how much infliuence it should have.

Out of interest what backtesting have you done to come to this overall conclusion? Are you confident that whichever % risk you decide to use, will return a positive expectancy for your system?

I have already posted this on another thread but looking at % risk per trade is all well & good when you are developing a strategy but once trading live, other metrics are more important to monitor. These include Avg DD, Max DD, number of consecutive losses, smoothness of your Equity Curve, etc, etc.

For me, I use an initial risk of anything between 1-2% when I develop a new system. After carrying out backtesting, I am able to see these above metrics of the system. Then, by adjusting the % risk, I am able to optimise the system, so as to meet my own requirements.

During this "testing" phase, I have had some very interesting observations. In one example, increasing the % risk resulted in no real improvement to Net Results yet the Max DD increased beyond an acceptable level. In another example the opposite happened!!

 

[Rhody Trader]

So - for me I hold max 10 positions at any one time using a 10% stop-loss.(As opposed to using a stop-loss outside teh noise) i.e. 1% risked per trade assuming no leverage.

Howver - If i do decide to risk,say,. 2% then that allows me to do 2xleverage. And 3% allows me 3xleverage. etc.

So in that scenario I do think that defining ones risk has everything to do with teh amount of leverage used.

And that is why I am trying to find out that by if I can guess that I have an average expectancy loss of say, 6.66% of the initial 10% on each trade, thereofere I can actually take 3xleverage but still only risk 2% on each trade.

Or - if I can guess that I have an average expectancy loss of say, 3.33% of the initial 10% on each trade, thereofere I can actually take 6xleverage but still only risk 2% on each trade.

ANd that is what I am trying to establish here.

RhodyTrader thinks my logic is flawed and suggests I shoudl only look at teh max potential loss on anyone trade. I beg to differ and think that average expectancuy loss should certainly have some influence on the risk per trade. My quandry is I am trying to figure out how much infliuence it should have.

I never said you should look "only" at the max loss, but that you should look there first.

The question you have to answer is this: What happens if all 10 of your positions hit their initial stop (or worse) at once. Based on your 10% stop, that would be a 10% loss on your whole portfolio. If you were levering up 3 times, that would be a 30% loss.

And yes, you most definitely could see all 10 of your stocks get stopped out like that in one shot. The question you have to answer is how big a drawdown you're willing to accept in that sort of situation. The expectancy of your system - based on testing, of course - will help you figure that out, as it speaks directly to the ability of your method to recover from a drawdown.