So I'm trying a new a trading strategy of not risking more than 1% of my portfolio on every single trade.
This way of managing the risk of my trades means that if I am wrong 10 times in a row I will end up with 90% and survive. When I enter a trade I am looking for a 1-3% PORTFOLIO gain. ( that % is not the gain on the shares I just bought but for the entire portfolio amount, meaning that the shares I just bought need to increase much more than just 1-3% depending on the amount I bought)
So here is the ...not so obvious (at least for me) math behind dollar cost averaging. If you thought that as the shares you just bought go down closer and closer to your stop limit, you can reduce the risk by buying more at a lower price ....well you are wrong.
Let's pretend your portfolio is $1,000. For whatever reason ( be it TA , news or just your gut feeling) you think EOS's price is about to go up. Let's also pretend that the current price is $10.
Since we already know we are going to risk no more than 1% of $1,000 we need to come up with a stop loss limit. And that one you have to decide again based on TA/ gut feeling etc. Let's pick a stop limit at $8. ( if the price goes below $8 your stop limit order will execute, selling your shares and take the 1% loss of your portfolio).
So by doing the math:
(Position size = (risk*budget) / (entry price-stop loss)
We are allowed to buy 5 EOS @ $10 with a stop loss limit at $8. If we want to buy more we need to set a higher stop loss limit. ( If our stop limit is at $9 than we are allowed to buy 10 EOS ....but let's keep it at $8 for the sake of the argument).
Now...if the price starts going down to $9 after we bought it ...we might think that buying more EOS at this price will lower the average cost and reduce our risk while keeping the same stop loss. Well that's not really the case and here is why:
If we buy 10 more EOS @ 9$ this means that our average cost goes down to $9.33 for 15 EOS. But now we have invested a bigger % of our portfolio. Which means that our stop limit can't stay the same if we don't want to risk more than 1%.
So now for 15 EOS @ $9.33 our stop loss must go higher to $8.66. Which means that we are even closer to the stop loss limit ... the price only needs to go down $0.33 and the stop limit order is executed.
So what am I trying to say here is that dollar cost averaging DOES NOT reduce your risk. This might be obvious to some experienced traders ....but it wasn't to me. I just found out about it and wanted to share with you.
I'm out.
Cheers!
