You’ve done your analysis and are ready to take the trade. Next question is how much do you buy? The tendency is to buy what you can afford or to equally partition your portfolio in to similar sized positions. However, each of these position sizing methods fails to acknowledge good risk management. Some stocks are more volatile, and therefore riskier, than others. Here is how I size my positions.
The first step is to define the risk of the trade you are planning to make. I use a simple method for this; entry price – stop loss price. Yes, most investors don’t go in to a trade planning to lose but you must define that price level where the market will have proven you wrong and you need to take the loss and get out. Small losses are manageable, big losses hurt long term performance both financially and emotionally.
Here is a chart of Aphria (T.APH) showing at the green arrow a recent buy signal using my Action Breaks strategy. The green line shows the entry price of $14 and the red line shows what I would use as my stop loss point, $11.
Why $11 for the stop loss? That was the low point before the market got excited about this stock and bought it aggressively. The abnormal price and volume activity on the buy day are what catch my interest; it demonstrates that the buyers have become very motivated to act on the stock. The day before was quiet so the implication is that if the cause of the strong buying on the green arrow day was not justified, it would sink back down to where it was before it started to go up.
I put my stop loss points at the floor before the buy signal.
This first step determines that the risk of the trade is $3 per share ($14 entry price - $11 stop loss price) The next step is to determine your risk tolerance.
How much are you willing to lose on any one trade? The answer to that question has many considerations. How much capital in your portfolio, your age, your emotional response to risk, investment goals etc. This is something you must determine for yourself but a few guidelines.
First, don’t risk more than 5% of your portfolio on any one trade (although that number should come down as you get closer to retirement). 1% may be appropriate for many.
Second, don’t take a position size that is more than 10% of your total portfolio.
Finally, and most importantly, don’t risk more than you can sleep well with.
For the sake of this example, let’s assume you have a $100,000 portfolio and are willing to risk $1000 on any one trade. Given the $3 a share risk of this trade you will buy 333 shares. I typically round the position down to either 330 or 300 shares.
330 shares at $14 a share is $4,620 plus commissions. Less than 5% of the total portfolio size.
What this position sizing method does is make every position in your portfolio have the same risk (with one caveat which I will explain in a moment). A more volatile low-priced stock will have a lower dollar position size. A more established large cap stock which will tend to trade with less volatility and will have a higher dollar position size. They will all use the same risk tolerance to determine the number of shares to be bought.
Here is the caveat. While buying a smaller position in a more volatile low-priced stock will use the same risk tolerance, there is a greater risk that these types of stocks will gap in price if something goes wrong. A $4 junior mining stock that has bad exploration results could gap down to $2 on bad news, jumping through the stop loss price and giving a bigger loss than planned. Downward price gaps can happen with large cap stocks too, but it is less frequent as these companies tend to have more predictable earnings. Be aware that having a stop loss point does not mean that is where you will get out. The risk you take could be higher, especially with less liquid stocks.
Size your positions based on:
- The risk of the trade
- Difference between the entry price and the stop loss price
- Your tolerance for risk
- How much are you willing to lose on any one trade?
Tyler - www.stockscores.com