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Technology Stocks : Rambus (RMBS) - Eagle or Penguin -- Ignore unavailable to you. Want to Upgrade?

To: hdl who wrote (80204)	12/8/2001 8:00:18 PM
From: Bilow	Read Replies (2) \| Respond to of 93625

Hi hdl; Re: "I think one is over-diversified and has too many stocks to follow, if he has no more than 2% in any one stock." The restriction is not 2% of your capital into a single stock, the restriction is 2% of your equity at risk in a single trade. The risk may be more or less than the amount of money you have to put up to make the trade. For example, if you're buying options with the intent of holding them to expiration, the 2% limit would apply directly. (I.e. don't put more than 2% of your equity on stock options for a particular stock.) If your trade was to make a bet on futures you could be at risk for more than the equity you had to put up. But if your trade was on a stock, and your trade involved getting out with a limited loss, then you can put more than 2% of your cash into a single trade. Example. Suppose you were buying Ford (F), you had an account with $200K in it, and you wanted to restrict your risk to no more than 2%. Ford is now at $17, and it's been between $14.7 and $31.4 over the last year: finance.yahoo.com Your trade might be to buy Ford at $17 1/8, with a stop loss to sell it if it gets below $15 again. In the event of that stop loss hitting, you figure Ford might drop as low as another 50 cents to $14.50. Your total at risk would then be $17 1/8 - $14 1/2 = $2.625 per share. Now 2% of $200K is $4K, so to max out yourself on Ford would require $4000 / $2.625 = 1,500 shares. Buying that much Ford would require 1,500 x $17 1/8 = $25,687.50, which is *12.8% of your total equity, not just 2% of your equity. In other words, if you were buying stocks at about the risk level of Ford, and you didn't want to buy on margin, and you were going to dump anything that dropped about 10% or so, it would take about 8 stocks to use up your $200K, not the 50 that would be implied by the simple application of the 2% limit. Another example. Suppose you were day trading MSFT, and you wanted to go short at $68 per share, and you figured on covering with a loss if it got as high as $68 1/4 per share. You might suppose that on a quick day trade you could get out for no worse than 1/8 higher than that $68 1/4 per share or around $68 3/8. Therefore your "risk" on the trade would be about $3/8 or $.375 per share. On that same $200K account you could then short $4K / $.375 = 10,600 shares, or $720,800.00 worth of stock. But you wouldn't be able to short that much MSFT on a $200K account (unless you had some daytrading privileges that I won't go into here). In other words, the (1) risk limit of 2% will not always be the limit to how many shares you can put on in a trade. The other limits are (2) the margin limit enforced by the brokerage, (3) a limit due to the illiquidity of that particular stock, and (4) an amount due to how trading in that stock is executed. An example of the 4th limit might be an account which intends on using automatic execution against market makers (such as the DOT system at the NYSE): instinet.com In other words, the "risk limit" is only one of four limits that restrict the maximum number of shares that a prudent trader can put on for a given trade. A great explanation for why the risk limit exists is present in this book: shop.barnesandnoble.com An example of why risk limits exist: Suppose you had a system for counting cards in Black Jack, and that you could make a profit of about 2% on your bets at the local casino. Suppose further that you have a cash pile of $200K, and you want to make a living off of it. How big should your bets be? If you make your bets too small you're going to make too little money. With $200K in the bank it would be silly to play at the $1 table. If you make your bets too large there's a high probability that you're going to bust out. Putting $50K down per hand is too much to safely make money off that $200K. Only four losing bets in a row will bust you out. The mathematical theory of how to choose the bet size is covered in the above book. But if you want to cut to the chase, and you're not interested in a bunch of mathematics theory, just use the 2% limit that I mentioned. (G) There is a case where I would make an alteration to the 2% limit, and that's if the amateur is trading based on an income* rather than his *savings. If he has a steady income that he intends to trade with, than he can capitalize the net present value of that income before taking 2% to calculate the risk limit. Re: "It would take too much time to follow them. Once, you have that many holdings, you might as well buy an index fund." I agree! Most individual traders would do better in an index fund. But more importantly, you should ask the question: Why is it that fund managers are very highly likely to obey the 2% limit (by diversifying their accounts)? Amateurs should consider this fact carefully. If the professionals play by risk diversification, then why don't the amateurs? Re: "Reading a recent Fred Hager link on this thread gave me better pleasure and fantasies than reading Playboy ever did.*" Somehow I'm not surprised. I'm here for entertainment, and besides, I only read Playboy for the articles. (No, really!) -- Carl