The Backbone of My Trading System

Apurva Sheth
26 January 1950: It's not just any other date in history. That was the day the Constitution of India came into effect. The Indian Constitution was one of the first steps taken by independent India to form a democratic nation.

The Constitution lays down the foundations of our government - the basic rules we, as a nation, agree upon and follow. These rules are the backbone of the functioning of our country. These rules have helped govern a country as diverse as India for 67 years.

A well thought out set of rules is a must to govern any activity. Trading is no different. If the constitution is the backbone of our country, the backbone of trading is risk management. Trading is a high-risk, high-reward activity. Your success in it will depend on how well you manage risk.

As you probably know, Saturday was the Equitymaster Conference. (By the way, if you missed the big event, here is your chance to get online access to the video recordings of the Equitymaster Conference 2016.) Then, on Sunday, we topped off the weekend with an options training workshop by Asad.

I thoroughly enjoyed interacting with our subscribers at both events. A common thread to some of these interactions had to do with the risk management in our short-term equity recommendation service, Swing Trader.

With Swing Trader, I aim to identify short-term trading opportunities in the equities cash segment with a potential to deliver 6-20% returns in a few days to weeks.

The Indian markets have had a rough ride since topping out in March 2015, which happens to be when Swing Trader went live. However, despite turbulent market conditions, we have managed to sail through with small losses. Most other traders haven't fared as well.

Of course, I am not saying that our strategy was perfect, and we have made some improvements to our systems and processes…

But a rock throughout has been our risk management system. Regrettably, many subscribers I met at the event were not fully aware of our system or how it works.

So please allow me to explain…

Our risk management system is simple:

  1. Risk not more than a fixed amount of capital on any trade.
  2. The amount at risk on any single trade is very small compared to the overall capital.

Here is step-by-step example.

Step 1: Set aside capital for trading

Ideally, your trading capital should not be more than 5% of your total allocation to equities. This number may vary depending on your risk appetite. This will be the amount you are willing to lose (all of it). Let's say you set aside Rs 3 lakh for trading equities.

Step 2: Determine percentage risk per trade

The percentage risk per trade will be a very small portion of your capital. Ideally, you should not risk more than 1% of your capital on any trade. I recommend 0.5% for Swing Trader.

Step 3: Determine absolute value at risk per trade

This is a simple multiplication of: trading capital * percentage risk per trade

In this case: 3 lakh * 0.5% = Rs 1,500.

Step 4: Determining number of shares to buy

To control the risk on a trade you have to determine the number of shares you will buy. To do this, you will have to identify the risk per share on each trade. The risk per share is the entry price minus stoploss. For example, if your entry price is 100 and stoploss is 95. Then your risk per share is 100 - 95 = Rs 5.

Finally, you divide the absolute value at risk per trade with the risk per share. In this case it will be 1,500 divided by 5. That equals 300.

So you will buy 300 shares at Rs 100 each. Your total investment in this trade will 300 * 100 = Rs 30,000. This is the amount you are allocating from you trading capital to this trade.

Contrary to what most people think, risking 0.5% on each trade is different from allocating 0.5% to each trade.

In this example, we are allocating Rs 30,000, or 10%, of our capital to this trade. But we are risking only Rs 1,500, or 0.5%, of our capital - that is, assuming you have the discipline to exit the stock if the stoploss is triggered.

This level of risk management is the backbone of my trading system, and it's the reason we've been able protect our capital through these tough times.

How do you manage your trading risk? Share your views in the Club or share your comments here.

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8 Responses to "The Backbone of My Trading System"
15 Oct, 2016
Apurva, your risk management system is great. Though, a couple of points to be highlighted. One, there is no consideration of brokerage, statutory expenses, etc in your examples for determining stock quantities to buy per recommendation. This, theoretically, could lead to faster erosion of funds allocated to Swing Trader if there are more misses than hits during a particular patchy phase of the market. Therefore, I take these costs into consideration on both buy and sell sides to determine my buy quantities. Second, your monthly and yearly performance figures do not take these costs into consideration. If you consider these costs, your performance figures would be inversely magnified (higher loss figure and lower profit figure). Do note this point and rectify your performance figures to give a more realistic picture.Like (1)
04 Aug, 2016
Dear Mr.Apurva, Thanks for your fairly lucid inputs on 'safe trading'. Going by the stop loss of of max5%, you have calculated Rs.1500 loss per trade. However the total no of trades in the 3lacs trading capital assuming fully committed will be 10nos leading to a total loss of Rs.15000. Say 5% of the capital as against the 0.5% proposed by you. There is also a convenient assumption here that you will find buyers for the stocks we are ooloading with stop loss. This may not happen all times and you may get stuck with unsold stocks and more losses! Please come back on this. RegardsLike (1)
16 Jun, 2016
in downward market or sideways even it mey happen stoplosses are hit we safeguard success calls and failed calls. thanks.Like 
10 Feb, 2016
Very nice mr apurva your trading system well doneLike 
03 Feb, 2016
sir, swing trader started March-15 now Feb-16 but you give every month net result loss only why not able to given profit in past 11 months? you said every script 6 to 20 % profit in few days holding but net month wise result and net 11 month result loss loss loss please select stock recommendation if any other good way ThanksLike (5)
28 Jan, 2016
Thank you for your lucid explanation on risk management system. Most of my misconceptions have been cleared. I only wish that you could have been as crystal clear at the beginning. I am not saying that you did not explain but you were not this clear. Like 
S unil
28 Jan, 2016
Sir, I have read your article with interest and it teaches a very simple method to manage risk and capital. However, instead of fixing your stop at a specified mathematical figure to manage losses across all trades, I follow a system of working out stops based upon volatility of the stock for the day. This way my stops do not get taken out easily. Thus, some stops would be close stops while others deeper. May I have your expert views please.Like (2)
Chintan Joshi
27 Jan, 2016
Great Job Apurva, This is really very beautifully educative article. This really gives you a right strength to persuade trading.Like (1)
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