Ask Colin

To deal with high market risk, I have halved my amount risked per trade. Now I often cannot buy sensible amounts. How do you deal with that?

I define market risk as the risk that relates to the movement of the overall market. Now (September 2002), I agree that the risk is high of further falls in the overall market. The way I deal with market risk is to only invest a portion of my capital in the market and hold the balance in cash on deposit.

So, if the market risk is high, in an extreme case, I might not be invested at all. However, that only applies in a very extreme situation. When the risk is simply high, I might only have 25% of my capital invested in the market.

The other important risk to manage is specific risk. I define specific risk as the risk associated with movements in the price of individual stocks. I deal with that by not risking more than a small proportion of my capital in each stock.

This sounds straight forward, but as you point out, if my stop-loss is a long way away from the entry point, then I may not be able to invest a sensible amount. A sensible amount has two aspects - whether brokerage is reasonable in relation to the total amount and whether the investment is big enough to make a reasonable contribution to results if successful.

Therefore, I not only have an upper limit on how much I risk on any one investment, but I have a threshold amount for the initial amount I invest in any one stock. The basic parameters are that I will risk up to 1% on any one stock, but I will not invest less than 2% of my capital on the initial position.

Thus, I manage market risk by reducing how much of my funds I have invested and I manage specific risk through the amount risked per investment. These two things are independent, in that they both relate to the total funds I have for investment. In other words, I do not change the position size calculation just because I am less than fully invested. To do so would be to allow for market risk at two levels.

This will tend to avoid the problem that you have of the number of shares you can buy not being sensible. However, there are still situations where I cannot buy a sensible number of shares - at least 2% of total capital. I deal with this in two ways:

1. I pass up the investment and look for other stocks where the stop-loss is closer to my entry price.

2. I look for a later entry point in the stock, when the stop-loss is closer to my entry price.

In your detailed question (I shortened it for the web site), you mentioned that instead of placing your stop loss under a trading range, you set it higher than that - say below a trough (support level) within the trading range. I generally don't do this, except in one situation - where there is a clear trend of higher peaks and troughs (a trend) in existence prior to the breakout. In that case I will use the last significant trough in that trend for my stop-loss, by setting it just below that trough.

I need to stress that this is my approach and it is certainly not the only way one can go about investing. I hope it helps by showing you what the issues are and the way I deal with them. I hope it helps in developing your own approach.

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