The 3% Risk Trading System

Last week I mentioned the 3% Risk Trading System which is much more aggressive than the 10% Rule used with the StockTradersHQ (STHQ) portfolio. Just a reminder before we proceed, the 10% Rule = 10% 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 10% Rule. Please do not get this system mixed up with the 10% Rule. The STHQ trade record is based on 10% 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 STHQ 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 $100,000 portfolio our maximum loss of 3% will be $3,000 in our first trade. If we are starting with a $25,000 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. 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 $3,000 (3% of $100,000) $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 $14,458 (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% = $3,000
$3,000 / $5.20 = 576 shares
576 X $25.10 = $14,458
$14,458 = 14.5% of $100,000 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 $3,000 of your $100,000 portfolio.

Buy Price = $25.10
Stop price = $22.10
Risk per share = $25.10 - $22.10 = $2.20
Max loss of 3% = $3,000
$3,000 / 2.20 = 1,363 shares
1,363 X $25.10 = $34,211
$34.211 = 34.2% of $100,000 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 ($3,000) 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% = $2,000
$2,000 / $2.20 = 909 shares
909 X $25.10 = $22,815
$22,815 = 22.8% of $100,000 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 10% position size rule. Let's take Example 1 again using our normal 10% position size rule. We will assume we will be stopped out of the trade with a 10% loss according to the STHQ trading rules.

Buy $25.10
10% of $100,000 = $10,000
$10,000 / $25.10 = 400 shares
Stop $2.50 (10% below buy price) = $22.60
Sell at $22.60 = $9,050
$10,000 - $9,050 = $950
$100,000 - $950 = $99,050

The loss of $950 = 10% of your 10% position but only 1% of your total $100,000
As you can see, the 10% Rule is more conservative compared to the 3% Risk Trading System. The 3% Risk Trading System is ideal in Bull markets, but performs poorly in flat markets. It is too easy to get whipsawed out of you position in a flat market, and those losses will add up quickly. However, in a Bull market, the 3% Risk Trading System should out perform the 10% rule. Using the 3% Risk Trading System, only four or five positions are open at any one time.

Example 4

If you bought JRCC when we first recommended it on March 26th (see chart) http://stockcharts.com/h-sc/ui?s=JRCC&p=D&yr=0&mn=4&dy=0&id=p29039817531&a=132229947&listNum=19
at $17.50, you would have done very well when it closed Friday 31.10. Let's use the 3% Risk Trading System with this real example. Keep in mind, JRCC is still running and should move higher next week.

Buy Price = $17.50
Stop price = $13.90 (based on $14.00 support on chart)
Risk per share = $17.50 - $13.90 = $3.60
Max loss of 3% = $3,000
$3,000 / $3.60 = 833 shares
833 x $17.50 = $14,578
$14,578 = 14.58% of 100K portfolio balance
Sell at $31.10 x 833 = $25,906
$25,906 - $14,578= $11,328
$100,000 + $11,328 = $111,328

The gain is $11,328 and your risk was only $3,000. This one trade could balance out almost four losing trades with a 3% risk level. This shows that you can lose 3 out of 4 trades and still break even if you keep your losses to a minimum. Remember to risk 3% of the new balance. This means, if the GENC trade was your first trade you now would risk 3% of $111,328 instead of $100,000. This is how you compound your gains very quickly.

To Reiterate

I can not stress this enough, it is imperative with this system to PLACE YOUR STOPS IMEDIATELY AFTER YOUR BUY ORDER IS FILLED. You are risking substantial loss if you fail to place stops with 34% of your capital at risk as with Example 2.

I hope you have enjoyed tonight's Commentary and the introduction of the 3% Risk Trading System. If at some point in the future we decide to open an aggressive portfolio, this is the system we will be using. We currently have two portfolios we trade, a long term portfolio (Dynamic Dozen) in which we buy and try to hold for a year or two and our short term swing trading portfolio which we trade in and out of positions frequently. I have described the 3% Risk Trading System in advance so you will be familiar with the system if we do decide to open an aggressive portfolio at some point in the future.

David Colletti
Founder
StockTradersHQ.com