Risk Management the Charles Dow Way: Stop Placement and Position Sizing with Dow Theory

The Importance of Risk Management

No trading strategy is complete without a solid risk management plan. Charles Dow understood this, and his principles can be used to create a robust risk management framework. The goal of risk management is not to avoid losses altogether, but to ensure that your losses are small and manageable, while your winners are large enough to offset them.

Stop Placement with Dow Theory

Dow Theory provides a logical and objective way to place stop-loss orders. In an uptrend, a stop-loss should be placed below the most recent secondary low. This is the point at which the trend would be considered to have reversed. In a downtrend, a stop-loss should be placed above the most recent secondary high. By placing your stops at these logical levels, you are giving the trade enough room to breathe, while also protecting yourself from a catastrophic loss.

Position Sizing

Position sizing is the other half of the risk management equation. It determines how much you will lose if your stop-loss is hit. A common rule of thumb is to risk no more than 1-2% of your trading capital on any single trade. To calculate your position size, you need to know your entry price, your stop-loss price, and the amount of capital you are willing to risk. The formula is: Position Size = Amount to Risk / (Entry Price - Stop-Loss Price).

Real-World Example: A $100,000 Account Trading AAPL

Let's say you have a $100,000 trading account and you are willing to risk 1% of your capital on a trade in AAPL. This means you are willing to risk $1,000. You want to buy AAPL at $150, and your stop-loss is at $145. The distance to your stop is $5. Your position size would be: $1,000 / $5 = 200 shares. If the trade goes against you and your stop-loss is hit, you will lose $1,000, which is 1% of your account.