I wanted to expand the discussion on risk, to build on the definition from the last post, and get into levels of risk that are generally considered acceptable, as well as mention the concept of "portfolio heat".
As I mentioned in the last post, many investors and traders do not understand the concept of risk, and so, are not in a position to be able to accept that risk. Risk is the difference between purchase price and stop level, times the number of shares or contracts taken on. The investor that takes on a position in a stock, ETF, or mutual fund, and does not know the price that he will get out, has not defined the risk that has been taken on. In fact, they will not know how much they risked, unless the position reverses and goes so low that they cannot take it anymore. Pain has defined risk for them. Many investors learned this in past bear markets.
Most trading authorities agree that an acceptable level of risk/position is around 0.5% to 1.0% of total account value. In a fictitious $100,000 sized account, 1% would be $1000. So simply divide the difference between purchase price and stop level into $1000, and you get the number of shares or contracts (for futures) that you can purchase.
Portfolio Heat- this is the total amount of open risk on the account an any given time. assuming that you have multiple positions on, and have been moving your stops up to protect profits, calculate the risk per position, and sum the total risk over all positions compared to the account. Most agree that 5% portfolio heat is acceptable. That means that if all positions reverse, and get stopped out, that you only suffer a 5% drawdown in value.
Thanks for reading- I hope that this helps.
