Have you heard advice such as “cut your losses quickly”, “do not risk more than 10% per trade”, “do not risk more than 6% of your portfolio” and similar? I have read about this in many books and I always wondered how to apply this advice to my tiny portfolio to protect it against loses. I always made it wrong and lost more than the advice recommended. But how to limit your trades correctly against inevitable loses? When I started trading a few years ago I was clueless about this topic. Later I created a strategy of money management and I though I finally solved this issue and my portfolio is protected. However a few days ago I realized I made another costly mistake. The mistake that reduced my portfolio by almost 14% within couple days even though my money management should protect it and I was supposed lose not more than 6%. What did I do wrong then?

### How many shares to buy?

To understand this question let’s take a look at money management in a nut shell first. This strategy is sometimes called a position limiting strategy. The goal is to buy a limited amount of shares, so if the trade goes against a trader, he loses only a limited amount of money instead of the entire portfolio.

For example if you have a small account of 2,000 of dollars, you may decide not to lose more than 3% of the account per a single trade.

For example, we want to buy Activision Blizzard Inc. (ATVI) with the last price, a potential entry at $12.88.

This means, we can afford to lose only $60.00 per this one trade:

portfolio value * lose per trade:

**$2,000*0.03 = $60**

This is a maximum trade exposure we will be risking if this trade goes against us.

Now we need to calculate a stop loss, which will be within the limit of the maximum trade exposure as calculated above.

I typically use ATR indicator to find out the stop loss, but you can use another approach instead. Most charting programs allow you to display ATR and I multiply the ATR value by 2.5 to get my stop loss. ATR tracks volatility of the stock, so using it should get you out of the daily volatility range, and you do not get kicked out too soon or unnecessarily too late. You can also set your own fixed percentage for the stop loss, for example 10% below the purchase price. However, if you use ATR multiplied by 2.5, as I do, (for ATVI the ATR value today is 0.4407) the stop loss will be at 11.78 dollars, which is 8.55% below the purchase price:

[12.88 * (0.4407 * 2.5)=** $11.78**];

[(12.88 – 11.78) / 12.88=

**];**

__8.55%__And now it is easy to calculate how many shares you can buy to stay within the numbers mentioned above:

max.exposure / (entry price – stop loss):

$60 / ($12.88 – $11.78) = __55.55__

Now, if the number has decimals, you always must **round it down**. In our example we can buy **55** shares only. If we buy more, we will risk more money than projected and soon or later you we will suffer a loss of the entire portfolio.

### How to limit positions per the portfolio?

Well, now we know how to calculate the single trade with limited number of shares to lower the risk per that one trade. However, we still can be opening unlimited number of trades (positions) and wipe out the entire portfolio even in our case our single trades were calculated properly. The way how to do this is to limit number of trades you can open at a time. If for example I make a rule not to lose more than 6% of the entire portfolio, the math is easy here.

If our single trade is limited to 3% of the portfolio value only, we can open max. two trades and risk no more than 6% of our account. In the case both trades go wrong and each of the positions loses 3% it will add up to only 6% of the entire account. In our example it will be $120 only.

We can open another trades only if the total risk, or exposure won’t exceed 6% of the account value.

This is what I did wrong last time and lost another 13.5% instead of planned 6%. When my original trades showed gains, I calculated how much exposure I have available to open new trades. For example I bought Visa (V) and Synaptics (SYNA) and both stocks showed some gains, so my total exposure available increased from -6% to some +5% so I could open 3 new positions:

My combined gain was $101 at some point:

gain / portfolio value

$101 / $2100 = **5%**

5% – (-6%) = **11%** of available exposure

11% / 3% = **3** more positions available at 3% risk rounded down.

So per this calculation I opened two new positions. This was completely **WRONG!**

Too late, I realized that I cannot size my number of positions based on the current gains or loses. When the market turned down and it happened last week when stocks corrected, all trades turned against me and I could see that I am risking more than 6% of the portfolio. This is not acceptable.

All the calculations above must be based on the current stop loss, not gains or loses, which are fluctuating. The stop loss limit is the actual risk we are exposed to, not the current gain, which may turn into a loss next day until we start trailing the stop loss up.

If we go back to the example above, our calculation should look like this:

total stop loss value (of all open trades) / portfolio value

$-221 / $2100 = __-11%__

Suddenly the numbers of exposure look different. If both trades go wrong and I will be stopped out I will lose 11% instead of 6%, almost two times more than allowed! This calculation also reveals I should have never opened my second, third and fourth trade at all.

For me this was another expensive lesson on money management and you can learn from it up front.

I created a spreadsheet in Excel with corrected calculations, which you can download here.

I use this spreadsheet myself to make calculations easy and fast. I also interlocked it to my trading account which allows me to download data directly from my trading account without manual typing. The spreadsheet is free and you can modify it as you wish. All cyan areas are editable, yellow fields contain equations so you should not edit them. If you have any further questions on how to use this spreadsheet or calculate the risk, just contact me.

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**Dividends4Life**

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Stock Market Analysis at **DeepMarket**

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“Now we need to calculate a stop loss, which will be within the limit of the maximum trade exposure as calculated above.

I typically use ATR indicator to find out the stop loss, but you can use another approach instead. Most charting programs allow you to display ATR and I multiply the ATR value by 2.5 to get my stop loss. ATR tracks volatility of the stock,” yeah! write!!!!