Wednesday, July 2, 2008

What is a Unit ?

I have had a number of enquiries as to what a unit is so I thought I would go into a little depth to explain it. Many think or assume a unit would be 100 shares of a stock or 1 contract of a commodity. Far from it and if only it were that simple.

Long ago I read the about the legendary trader Richard Dennis' turtle traders. Rather than re-invent the wheel I have taken his work and now employ it in my own trading. Mr. Dennis believed, as do many other SUCCESSFUL traders that money management is THE most important aspect of trading. I agree with this unequivocally.

The root of position sizing is in volatility or N.

N is the 20 day average true range or ATR on some charting services. If you do not have the service then the computation must be done by hand. Take it from me lots of work but there is a formula.

1 N could for example represent 1% of your account equity.

Thus a unit would be calculated as follows;

Unit = 1% of Account / (N x Dollars per point)

Here is a rough example for you to consider;

$500,000 dollar trading account.
Stock or commodity price $50.00
N = 4.00

Unit = $5,000/ ($4. 0 x 100)

Unit = $1,000/ $400

Unit = 1250

Therefore under this example a trader could take a 1250 unit maximum position. Under this scenario the trader would buy

1250 shares of XYZ stock or commodity at $50
Now with a stop loss at $46 (Entry price(50) less N (4) which is volatility of the stock.
The trader would now have a maximum risk of 1% of his account equity (1250 x $4)

Now how a trader employs the 1250 shares would be up to him/her. Do they get in all at once. Do they let in as the stock moves higher in 2 pieces or 4 or what have you. Lord forbid you average down or you will end up like Nick Leeson, the trader who believed averaging down was the path to nirvanic riches and he bankrupted his employer Barings Bank which also happened to be the Queen's bank.

The trader could now afford to be wrong 100 times before he is out of business and even as bad as this trader is no one is that bad ! You can adjust the formula, as I have to suit you specific circumstances and risk tolerances. As long as we let our winners run and cut our losses short we will succeed and live to trade another day.

I hope this helps.

Good speculating to you all and always remember that "an investor is a speculator who made a mistake and will not admit it".

1 comment:

m said...

Thanks for going more in depth into it.