Percent Risk Model in Trading
The Percent Risk Model is a risk management, betting strategy, and position sizing framework that helps traders protect their capital while maximizing potential returns.
This approach focuses on limiting the amount of risk taken on each trade to a specific percentage of the total trading account.
Key Takeaways – Percent Risk Model
- Capital preservation
- The model limits risk to a small percentage (typically 1-3%) of total account value per trade.
- Helps make sure that risk remains proportional to current capital.
- Keeping risk within reasonable constraints helps maintain trading longevity.
- Consistent risk exposure
- Traders maintain uniform risk across different market conditions and trade setups by using a fixed percentage.
- Promotes disciplined decision-making.
- Adaptive position sizing
- Position sizes automatically adjust as account value changes.
Definition and Purpose
The Percent Risk Model is a method of position sizing that determines the number of shares and contracts to trade based on a predetermined percentage of the trader’s account that they are willing to risk on each trade.
The primary purpose of this model is to:
- Preserve capital
- Maintain consistent risk exposure across trades
- Adapt position sizes to account fluctuations
- Promote disciplined trading
Key Components of the Percent Risk Model
Risk Percentage
The foundation of this model is the risk percentage, which is typically between 1% and 3% of the total account value.
This percentage represents the maximum amount a trader is willing to lose on a single trade.
Stop-Loss Level
A stop-loss order is a popular element used in the Percent Risk Model, especially for day trading/shorter-term trading.
It defines the price at which a trade will be closed to limit losses if the market moves against the trader’s position.
For longer-term styles of trading, it becomes more common to use protective options rather than stop-losses.
Position Size Calculation
The position size is determined by dividing the dollar amount of risk (based on the risk percentage) by the difference between the entry price and the stop-loss price.
We’ll go through this below.
Putting the Percent Risk Model into Practice
Step-by-Step Process
- Determine the account risk percentage (e.g., 2%)
- Calculate the dollar amount at risk (e.g., 2% of a $50,000 account = $1,000)
- Identify the entry price and stop-loss level for the trade
- Calculate the per-share risk (entry price minus stop-loss price)
- Determine the position size (dollar amount at risk divided by per-share risk)
Example Calculation
Let’s say a trader has a $50,000 account and wants to risk 2% per trade:
- Account risk = $50,000 * 2% = $1,000
- Entry price = $50
- Stop-loss price = $48 (the discretion of the trader)
- Per-share risk = $50 – $48 = $2
- Position size = $1,000 / $2 = 500 shares
In this example, the trader would buy 500 shares to maintain the 2% account risk.
If they wanted a wider stop-loss – say $2 instead of $4 – then they could halve the shares to 250 to keep the percentage risk the same.
If they wanted to go from 2% to 1% risk and a stop of $1, they could also do $500 shares.
It can be helpful to hardcode this on a spreadsheet to see how the position size changes as the inputs change.
Advantages of the Percent Risk Model
Consistent Risk Exposure
Using a fixed percentage of the account for each trade means traders maintain a consistent level of risk exposure regardless of the specific trade or market.
Automatic Position Sizing Adjustment
As the account value fluctuates, the position sizes automatically adjust.
This is done so that risk remains proportional to the current account balance.
Psychological Benefits
The Percent Risk Model can help reduce emotional decision-making by providing a more systematic approach to position sizing and risk management.
Capital Preservation
By limiting the potential loss on each trade, this model helps protect traders from large losses that could heavily impact their trading capital.
Considerations and Potential Drawbacks
Overtrading
Some traders may be tempted to take more trades when the volatility level of their portfolio is low and there’s not enough “action.”
This can lead to overtrading and increased transaction costs.
This also gets into topics about what’s a realistic return level and the common mistakes that newer traders make by blowing out their risk levels.
Opportunity Cost
Conservative risk percentages may limit potential profits in strongly trending markets or when a trader has a high-conviction trade idea.
This is where the concept of spreading bets and value betting comes into play.
Complexity in Certain Markets
Using the Percent Risk Model can be more challenging in markets with standardized contract sizes, such as futures or options.
For example, futures contract sizes tend to be quite large and sometimes illiquid, which can make implementing certain stop-loss and take-profit levels difficult.
It also means (typically) underdeveloped options markets.
Advanced Applications of the Percent Risk Model
Scaling Position Sizes
Some traders adjust their risk percentage up and down based on their conviction level in a trade or broader market conditions.
For example, they might risk 0.5% on lower-conviction trades and up to 3% on high-conviction trades.
Multiple Time Frame Analysis
Traders can apply the Percent Risk Model across different time frames – i.e., adjusting their risk percentage based on the holding period of the trade.
Portfolio-Level Risk Management
The model can be extended to manage risk across an entire portfolio, making sure that the total risk exposure remains within acceptable limits.
Integration with Other Risk Management Techniques
The Percent Risk Model can be combined with other risk management strategies, such as:
- The Kelly Criterion or a more conservative variant for optimal bet sizing
- Risk-to-reward ratios for trade selection
- Correlation analysis for portfolio diversification
Best Practices for Using the Percent Risk Model
Regular Account Revaluation
Regularly consider your account value to be sure that position sizes remain accurate and risk levels are maintained.
Backtesting and Optimization
Before using the Percent Risk Model in live trading, it’s important to backtest the strategy using historical data and optimizing the risk percentage for the specific trading strategy and markets.
Ultimately it comes down the edge, frequency, and payout, among other factors like transaction costs and frequency.
Consideration of Trading Costs
When calculating position sizes, traders should account for commissions and other trading costs to make sure that the actual risk aligns with the intended risk percentage.
Adapting to Market Conditions
The Percent Risk Model provides a consistent framework, but traders often adjust their risk percentages based on overall market volatility and liquidity conditions.
Conclusion
The Percent Risk Model is a framework for managing risk in trading – offering a systematic approach to position sizing that can help traders preserve capital and maintain consistent risk exposure.
By limiting the potential loss on each trade to a fixed percentage of the account, traders can protect themselves from catastrophic losses while still allowing for potential profits.
Nonetheless, like with any position sizing strategy or any component of your trading plan, carefully consider your individual circumstances, trading style, and markets when using this approach.
Also, combining the Percent Risk Model with other risk management techniques and regularly reviewing and adjusting the strategy can lead to a stronger and more effective risk management in trading.