Many traders use a rule of thumb of betting no more than two percent of their capital on any single trade. The logic seems reasonable: keep your losses small and save your ammunition for big winners. Sounds good, but does it work?

The answer is yes under the right conditions. Unfortunately, the rule implies that you could afford to lose 100% of your 2% stake on every losing trade and still survive. This is not true. Let's suppose you were making trades that were successful 50% of the time. You'd have to make an average of 100% on your winning trades just to break even. That doesn't sound very easy to do. Moreover, by making small bets, you'd have to win much more than 50% of the time to make any real money. So there's got to be a better way to manage risk. That's what Stop-Prices are all about.

Stop-Prices allow you to increase you're stake in any given trade and still manage risk. But you still need to know what you're doing. For example, if you bet 100% of your capital on "a sure thing," you must use a two percent Stop-Loss to meet the trader's guideline. But even that wouldn't satisfy me. I wouldn't bet 100% of my capital on anything. Actually, you should never put more than 10% of your investment capital into a single position and use a 10% or lower Stop to go with it. This controls your risk of loss on any single position to one percent of your capital.

If you desire to use a wider Stop-Loss to improve trading performance, you must, decrease your stake in each position or decrease the percentage of capital employed. Here's how it works:

If R = Percent Risk of Loss on any single position,
C = Percent of Capital Employed,
N = Number of positions, and
S = Stop-Loss Percent, then
S = (100 * R * N) / C.

When we went long with Contra ETFs in our Model Portfolio on January 30th, we deployed 25% of our capital with five positions and a Stop-Loss of 10%. What was R, the risk of loss on any single position?

R = (C / N) * (S / 100).
R = (25 / 5) * (10 / 100)
R = 5 / 10 = 0.50%.

An examination of our Model Portfolio shows that we lost 3.04% in that campaign with two winners and three losers. Had we gone long with 100% of our capital and the traditional 10 positions and 10% Stops, the damage to the portfolio would have been much worse. Thank you, Risk Management.