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3% Risk Trading System

The 3% Risk Trading System
 Last week I mentioned the 3% Risk Trading System which is much more aggressive than the 5% Rule used with the TWPD portfolio.  (5% Rule 5% of the portfolio value is placed in each trade.  As the portfolio value increases the dollar value placed in each trade also increases compounding gains while minimizing risk).  
 I have used the 3% Risk Trading System in the past with great returns; I have not used it recently though.  Fair warning: it is for aggressive traders only.  You will need tough skin and nerves of steal to use it.  If you have a heart condition you may want to consult your physician before entering any trades using this system. 

 The 3% Risk Trading System requires more capital to be allocated in each trading position compared to the 5% Rule.  Please do not get this system mixed up with the 5% Rule.  The trade record is based on 5% allocation in each trade and it will stay that way.  I am disclosing the 3% Risk Trading System as an alternative approach some members may find attractive.  If you decide to use this system please set up a separate account and do not blend this system in with your TWPD trading account. 

In the 3% Risk Trading System the money allocated to each trade will vary based on your buy point and your stop price (more on that later).  What is important is to limit losses to a maximum of 3% of your portfolio.  This means that in a $100000 portfolio our maximum loss of 3% will be $3000 in our first trade.  If we are starting with a $25000 portfolio then our maximum loss of 3% will be $750 in our first trade. 

Here is how it works:

Let's say you want to enter stock XYZ as it breaks above a resistance of $25.00 so you set a buy stop order at $25.10.  Once you are filled you MUST IMMEDIATELY set a stop loss order.  This stop loss is not an automatic 3%.  Instead the stop loss is based on previous support.  Let's say the support for XYZ is at $20.00.  Our stop would then be just under support at $19.90.  

To calculate the number of shares to purchase:
1.  Take the difference between the buy price and the stop price you have determined: $25.10 $19.90 $5.20.  
2.  Divide the difference into your risk level of $3000 (3% of $100000) $3000 / $5.20 576 shares

To calculate the value of your trade:
Multiply the 576 shares by the buy price of $25.10 to get a total of $14458 (14.5% of your 100K).  

Let's look at this example more clearly below along with two others. 

Example 1
Buy Price $25.10
Stop price $19.10
Risk per share $25.10 $19.10 $5.20
Max loss of 3% $3000
$3000 / $5.20 576 shares
576 X $25.10 $14458
$14458 14.5% of $100000 portfolio balance

In Example 1 you have to use 14.5% of your trading capital and you risk 3%.  

Example 2
In this example we will use the same buy price but a different stop price for XYZ.  The different stop price will depend on the chart and where you see the support levels.  Again you will risk 3% or $3000 of your $100000 portfolio. 

Buy Price $25.10
Stop price $22.10
Risk per share $25.10 $22.10 $2.20
Max loss of 3% $3000
$3000 / 2.20 1363 shares
1363 X $25.10 $34211
$34.211 34.2% of $100000 portfolio balance

As you can see in Example 2 you will use 34% of you portfolio balance because of the tighter stop you have placed on the trade.  You risk the same amount ($3000) but you must use more cash in the trade.  

Example 3
In this example we will use the same buy and sell points as Example 2 but the risk will be narrowed to 2% instead of 3%.  This system can be adjusted to risk any percent of your portfolio you wish.  You can bump it up to 5% risk if you wish.  It is the same formula; you will just be adjusting the dollars you want to have at risk. 

Buy Price $25.10
Stop price $22.10
Risk per share $25.10 $22.10 $2.20
Max loss of 2% $2000
$2000 / $2.20 909 shares
909 X $25.10 $22815
$22815 22.8% of $100000 portfolio balance

As you can see it does not matter what you pay for the stock or how much of your portfolio goes into each trade as long as you risk only 3% (or whatever % you are comfortable with) of your total portfolio.  Some trades will cost more or less based on where you determine the stop price to be on the chart to insure a maximum loss of 3%. 

This is obviously a much more aggressive approach then our 5% Rule.  Let's take Example 1 again using the 5% Rule.  We will assume we will be stopped out of the trade with a 10% loss. 

Buy $25.10
5% of $100000 $5000
$5000 / $25.10 200 shares
Stop $2.50 (10% below buy price) $22.60
Sell at $22.60 $4520
$5000 $4520 $480
$100000 $480 $99520
The loss of $480 10% of your 5% position but only 0.48% of your total $100000


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