There are three vital points to stock market success:

1. Trade in the direction of the trend
2. Use an effective exit strategy
3. Use effective risk management

Strategy 1 and 2 are widely covered in most trading books and articles, so let’s take a look at strategy three in more detail.

Van Tharp in his excellent book “Trade Your Way to Financial Freedom” addresses the issue of risk management or as he calls it position sizing. It is generally accepted in the trading world that to be successful trading shares your risk management means that the maximum amount of capital you can risk on any trade is 2%.

This means that if you have capital of $50,000 the maximum you should lose on any trade is 2% of $50,000 or $1000, if the trade goes wrong.

What is the best Position Sizing Method?

Van Tharp compares a number of different methods for calculating the position size or parcel size to use. He selects a number of shares and trades $1,000,000 in and out of these stocks over a five-year period. Note all of the different models look at the same trades. The only thing that changes is the amount of money on each trade.

The results are as follows:

• Model 1: Buy 100 shares of every trade Profit: $32,567
• Model 2: Buy 100 shares/$100,000 capital Profit: $237,457
• Model 3: Place 3% of our capital in each trade Profit: $231,121
• Model 4: Risk 1% of our capital in each trade Profit: $1,840,493
• Model 5: Limit losses to 0.5% of volatility (using ATR) Profit: $2,109,266

The difference between these models is dramatic!

A variation of model 3 is what most people would be using to approach the market, placing 10% of their capital into a trade. This will give better results than model 3 but still will not approach the results that are achieved in model 4 or 5.

In this model if we have $50,000 in capital we place $5,000 on each trade. We then limit our loss to 10%, which can be achieved by using a stop loss at 3-7% and allowing for brokerage and slippage. This means that if the trade goes wrong we stand to lose a maximum of 10% of our parcel or $500.

A more advanced strategy is looked at in detail below. This strategy is based on calculating the risk on each trade or Model 4 outlined by Van Tharp above. Here we take into account where we enter the trade and where we will exit if the trade goes wrong.

In order to use this model we plan where we get in to the trade and where to get out if the trade goes wrong. The potential loss is then calculated and the amount of capital we can place on any trade is then worked out. Take our total capital of $50,000 and let us risk 1% of this on any trade. This means that if the trade goes wrong we will lose a maximum of $500.

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