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Position Size to Determine How Many Shares to Buy

January 15, 2008 by 18 Comments

Let’s say (hypothetical): The market is trending higher. You find a stock to buy. You setup the proper risk-to-reward scenario.

So, how do you determine how many shares to buy?

Let’s setup a few hypothetical scenarios with three investors trading different size accounts.

  • Trader A has an account with $100,000
  • Trader B has an account with $50,000
  • Trader C has an account with $10,000

This exercise will teach novice investors how to properly position size their trades, preventing you from blowing-up your account or risking too much on one position.

These examples will buy the same stock (XYZ in this case) but we will do so with different stops based on different trade setups: 5%, 10% and 15% sell stop. The positions will also be placed in three different accounts. My free excel position sizing spreadsheet is the only tool I am using to determine the size of each position based on the entry price, sell stop (risk) and size of the account.

The number of shares change but the risk stays the same! Let me say that again, the number of shares change but the risk stays the same for all three traders.

Please note that these examples don’t consider other variables such as commissions, slippage, etc. Please read the book by Van K. Tharp to study the detailed models of position sizing. I will also like to note that it is very difficult to employ position sizing strategies with accounts smaller than $10,000 (even this is a small amount and can blow-out if not traded carefully).

Total risk of the accounts will be 2% in each scenario!

Trader A ($100,000 account)
Example #1:
Stock XYZ is trading at $60 per share
Portfolio size of $100,000
The stop loss is 5%
Risk will be $2,000 = ($100,000*2%)
Amount to Trade at 5% stop: $40,000 = ($2,000 / 5%)
Shares to be bought: 667

Example #2:
Stock XYZ is trading at $60 per share
Portfolio size of $100,000
The stop loss is 10%
Risk will be $2,000 = ($100,000*2%)
Amount to Trade at 10% stop: $20,000 = ($2,000 / 10%)
Shares to be bought: 333

Example #3:
Stock XYZ is trading at $60 per share
Portfolio size of $100,000
The stop loss is 15%
Risk will be $2,000 = ($100,000*2%)
Amount to Trade at 15% stop: $13,334 = ($2,000 / 15%)
Shares to be bought: 222

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Filed Under: Position Sizing

A Technique for Profit Taking

October 4, 2007 by 8 Comments

Use a stop, don’t use a stop. Make it a hard stop, make it a mental stop.

What do you do in a market like today when you have profits in multiple positions but you don’t want to give it all back? You want to continue to ride the winners but at the same time, you want to maintain the unrealized gains in your account.
HOW?

Most investors and many more market pundits continually talk about setting stops; they range from physical stops to mental stops to trailing stops to support stops to retracement stops or even moving average stops. It is easy to set a mental stop before you enter a position based off of your money management rules such as position sizing and expectancy but will you do it.

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If you have a $100,000 account and want to risk 1% of the account on a $50 stock with an 8% stop; we know that the trade will allow you to buy 250 shares with a worst case scenario sell stop of $46.00 (assuming a 1-R risk of $4). This is wonderful but what should a trader do once the position gains 20%, 30% or 50%?

Where should the profit-taking-stop be placed? We want to eliminate the chance of losing the unrealized gain without cutting the stop too tight. We don’t want to sacrifice our possibility of riding a real winner, otherwise known as a home run stock (a 10-bagger as Peter Lynch calls them)! Loosen the stop as you feel comfortable as longer term trend traders will allow for larger swings and draw-downs from peak gains. Shorter term swing traders may agree with the tighter retracement stops explained below.

Many books attempt to explain how to take profits and several academics offer advice but most of it is fluff and biased to opinion. I have heard traders claim that they take a third of the position down after making a 20% or 30% gain while other traders take down half the position once a gain reaches 50%; but is this the correct way to manage money and positions?

Keeping things simple, we could implement a combination of a trailing stop and a retracement stop based upon the actual gain at any point in time. In a bull market (like 2007), I will allow the system to loosen itself so I can handle a healthy pull-back without selling before a possible larger move. I would increase the size of the profit retracement stops when things are trending higher on a weekly basis. Let’s focus on a method for locking in profits without giving back too much as a swing trader.

For the sake of this example, I will continue to use the trade suggested above as the round numbers should be easy to follow.
Account Size: $100,000
Risk: 1%
Stop Loss: 8% (varies based on risk/reward setup)
Share Price: $50

Shares to Purchase: 250 or $12,500
Sell Stop: $46.00
Worst case loss: $1,000 or 1%

If you are unsure of how I came up with the numbers in this example, please take the time to visit my position sizing calculator and the post titled: position sizing and expectancy.

Assume we place a position and it is up over 20% after the one week of trading. What should I do to protect the profit I have already made?

    Scenario #1:
    At $60, I will set a stop based on a 30% profit retracement.
    To do this, you need to multiply the profit of 20% (or $10) by a 30% stop: $10*30% = $3
    At this point in time, I will look to close the position and lock in gains if the stock drops more than $3 from the $20% threshold ($60 in this case). My trailing stop is now $57 which guarantees me a total gain of 14%.

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Filed Under: Expectancy, Position Sizing, Selling

Reinforce Position Sizing

September 18, 2007 by 9 Comments

All traders and investors must learn position sizing so they don’t run the risk of ruin.
I have decided to post what I was writing on a forum recently after someone asked a few questions about diversification and the number of positions one should hold.

Traders should never risk more than 1% or 2% per trade. Some traders I know start by risking 5% of their account but will lower the risk after each successive loss. For example, they will drop the risk to 4% after a loss, then 3% if another loss occurs and so on until they are risking very little during a long term losing streak. I don’t trade this way but it may be a preference for some of you.

How do we Calculate Position Size?
We can determine how much to place on each trade by assuming a $100,000 account with 1% risk on each position. Using a basic trading approach (for example purposes only), we will place stops approximately 8% below the ideal entry area or pivot point. Please use more advanced methods for locating the ideal stop rather than a general 8% rule. Look for the ideal risk-to-reward setup based on recent support and resistance levels and set your stop and potential target accordingly.

Use and Download the Position Size Calculator I created in Excel.

$100,000 Account
1% Risk = $1,000
8% Stop Loss
Position Size will be $12,500
We calculate the position size by dividing the 1% risk by the 8% stop loss or $1000 / 8% = $12,500.

If the stock we are watching has an ideal entry of $50, we now know that we can buy 250 shares or $12,500 worth of stock. Our stop loss is $46 or 8% of $50 and our maximum loss is $1,000 of the original $100,000 portfolio.

So, why can’t we risk more per trade and obtain greater rewards?

Think about it: Even the best systems can and will have losing streaks of 10 or more (not often but it can happen). Historical testing shows us that profitable systems can and have lost 20 times in a row. If you are risking 5% or more without proper position sizing: YOU WILL BE TOAST! CLOSE TO DONE! Very hard to come back!

Fortunately, my longest losing streak ever was eight but I don’t day trade so my opportunity for longer losing streaks has been held in check. But, I have only been trading for 10 years so will assume that I will extend that streak one day (it’s the way the market works).

***EXAMPLES BELOW ARE SIMPLE AND THEORETICAL SO EVERYONE CAN FOLLOW FOR EDUCATIONAL PURPOSES ONLY***

  • At 1% risk (good for accounts above six figures), it would take hundreds of losing trades to bring on ruin. You will risk 1% of total equity, not the $100,000. So, if you lose ten consecutive trades, you will still have approximately $90,000 minus slippage, trading fees and other commissions, etc… So at $90,000, your risk is now $900 maximum!
  • Using 5% risk, your account will be below $60,000 capital from $100,000 after 10 consecutive losses. You now need to trade and make back 65% on your money to break even. Do you make 65% a year in the market now? Most people don’t.
  • Ten losses at 1%; you are only down 12%. A very obtainable come back!
  • Now, let’s look at 18 losing trades and 2 winning trades over a 20-trade period.
  • Use 1% risk with trade #5 and trade #18 winning 4% and 7% respectively (all other trades losing 1%): ~$92,000 account (only down 8% with 18 losses and 2 small winners)
  • At 5% risk with trade #5 and trade #18 winning 10% and 12% respectively (all other trades losing 5%): ~$48,000 account (I upped the winners but the account was slashed in half – you now need to make 100% to break even).
  • You claim that 18 losses over 20 trades won’t happen! Well, I must say you are dreaming in lala-land because it happens to the best in the business.
  • If you risked 5% and lost 20 consecutive times, you would be left with approximately $35,000. How long will it take you to break even?
  • At 1% risk, 20 consecutive losses bring you down to $81,000 (a tough string of losses but you are still in the game)! A 25% account gain breaks you even.

Now, image what most people start with: $10,000 or less! And then add the fact that they don’t know or understand how to properly position size – they are usually broke within a few trades because they bet the house on every trade and then emotionally freeze when things go wrong, taking losses of 25%, 50% or greater!

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Filed Under: Position Sizing

The Fear of Losing Money

July 23, 2007 by 8 Comments

Many investors fail in this world due to their fear of losing money. Brilliant people continue to fail at trading the markets because of their emotions, not their intelligence or their work ethic. It’s their psychological make-up and their pre-programmed society based beliefs as partially explained in The Holy Grail of Trading: It’s not your System.

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I don’t want to confuse the concept of conserving one’s wealth by employing proper money management techniques and the actual fear of going broke. Fearful investors base their entire system, thoughts and style of investing on a negative thought process or a negative mental attitude. Successful investors, whether it is stocks, real estate or businesses, always develop strategies to protect from the down-side by focusing on the reward versus the original risk. Successful investors develop systems with expectancies that allow them to negate emotional fear by knowing what can happen if the investment fails. Successful investors are emotionally prepared to handle the side effects of losing money. Unsuccessful investors think about losing the initial investment and more often than not, pass up on a potential golden opportunity.

How many times have you heard a person say: ‘if I only put my money into that stock or that piece of real estate”? These same people are also the ones that continue to pass up on potential opportunities today because they are scared to lose. Nothing comes easy and life rarely serves up a free pass without some form of risk attached. When speaking in terms of stocks, an investor must place money after their best ideas or they will never know if they have a winning system. Many people paper trade and claim they can pick winners but I view them as fearful of losing money. The fear of money and the fear of losing are two of the main reasons why so many people go broke on Wall Street.

If you don’t fear money and can accept losing as part of the game, you will eventually become successful.

A scared poker player can serve as a perfect example of the type of person that fears to lose money. Take the time to sit at any $1-$2 no-limit hold’em game at a casino and you will quickly realize who fears money and who plays without fear. Good players may continually lose because they fear the dollar and fail to play according to their strategy. I have seen several bad players win lots of money at the tables because they bully the scared players out of their hands. They essentially make suckers out of the better player so in the end; the better player goes home broke and emotionally damaged.

For example: let’s say you are dealt a KK and raise on the first bet but one of these fearless “garbage bully players” re-raises all-in to scare you out of the pot.
Would you fold?

I have heard many stories of players folding high quality hands due to their fear of getting a bad beat. In this case, the bully can only represent one hand that can beat yours, so the odds are heavily in your favor so you must call and call quickly (don’t have fear when the odds say you should win). Two remedies exist for the fear of a bad loss: a bankroll that can withstand a few bad beats and a strategy that capitalizes on hands with high odds for potential winners. Over the long term, you will be a consistent winner but must understand that beats will happen and some of them will be large (if it is a bad beat). Assuming that you let go or cut poor hands short, these larger losses can be avoided consistently. In poker and in life: scared money is dead money!

072307_chrometophobia.jpg

The same principal holds true in investing and in life. The people that assume the risk and calculate the odds of success are typically the ones that come out ahead with larger bank accounts. They don’t focus on the losing aspect of a deal and never blurt out the words “what-if”. To repeat, they don’t ignore possible failures as they prepare for the worst and expect the best. I will not deny that I have been in situations where I was scared to lose but that helped me seek out the answers to consistent winning. Losing will always sting but I now accept losing as part of the game.

I expect to win each trade but ultimately understand that some will fail and it’s ok as long as I don’t let it become catastrophic. I have learned to accept losing trades, losing money and I have challenged the fear of money. I place risk under control by developing and using a positive expectancy system, position sizing and money management techniques that eliminate my fear of losing money. I may lose many small battles but I depend on my system to win the ultimate war. I am a trend-trader so my wins are large in a market similar to what we have just experienced.

Read this quote from the movie Rounders:

“In “Confessions of a Winning Poker Player,” Jack King said, “Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career.” It seems true to me, cause walking in here, I can hardly remember how I built my bankroll, but I can’t stop thinking about the way I lost it.”

That quote can be tied to investing with great accuracy.

One more quote that fits with the article I have written about the fear of losing money:

“They’re trying to goad me, trying to own me. But this isn’t a gunfight. It’s not about pride or ego. It’s only about money. I can leave now, even with Grama and KGB… and halfway to paying Petrovsky back. That’s the safe play. I told Worm you can’t lose what you don’t put in the middle. But you can’t win much either.”

What are you afraid of?

Filed Under: Expectancy, Poker, Position Sizing, Psychology

The Holy Grail of Trading: It’s not your System

July 11, 2007 by 14 Comments

Do you have a wonderful trading system, one that consistently makes you money? You probably believe that you have found your holy grail but this couldn’t be further from the truth. Your system has very little to do with consistent profitability in the markets.

I often here amateur investors talk about that the “best way” or “only way” to invest and argue why their way is better than everyone else’s. The passion and energy exuded by these novice investors is wonderful but they are missing the point completely. No one can say that options are better than stocks, commodities are better than options or forex is better than everything, etc… Each investor develops a system that is suited to their own personal character traits and they use a vehicle (stocks, options, forex, commodities, real estate, etc…) that can help them reach their goals.

Investors also debate systems within a market such as: trend trading, swing trading, scalping, shorting, day trading, buy and hold, fundamental trading, technical trading, Elliot wave theory, moving average crossovers, etc… They all work if the “person” understands the holy grail of trading. And that is being able to understand YOU and how your mind works.

However, it is not the system that makes one successful. It is YOU that makes the system work properly. What do I mean? Each individual must master their own personal psychological impacts on their trading results. You must work on YOU to become consistently successful! I recommend reading The Disciplined Trader by Mark Douglas if you would like to understand the psychological trader in you.

To say that one system or vehicle is the “way to go” is ignorant.

Pick up any Market Wizard book and read how these men and women made hundreds of millions in the markets using different systems. The only thing they all had in common was money management and risk management. That’s ALL! Every one of them traded in different ways and used different vehicles but they all watched their risk, calculated proper position sizing techniques and understood their system’s expectancy.

Money management, also termed as risk management is a major part of the holy grail of investing, NOT THE SYSTEM! Novice investors will eventually understand this after many years of trading (some quicker than others).

So, if someone ever tells you that their “system” is better than yours, turn away and run and run fast because they don’t know what the hell they are talking about.

Here are some examples supporting this idea from the Market Wizard books:

  • Michael Marcus turned $30,000 into $80 million trading futures
  • Michael Steinhardt ran a fund that averaged 30% annual return over 21 years trading stocks
  • Tom Baldwin started with $25,000 and eventually traded $2 billion a day in T-bond futures on the floor or in the pit.
  • Paul Tudor Jones ran funds that averaged triple digit returns for five consecutive years trading multiple markets
  • Ed Seykota realized an astounding 250,000% return over 16 years (yes that says 250,000%) managing accounts trading in the futures markets – possibly the best trader of our time
  • Bill Lipschutz traded currencies with a staring account of $12,000 (started out as an architect – very motivating for me since I started the same way).

The list can go on forever but the point remains the same; they all traded different markets with unique systems from different locations (the floor, an office or their home in the mountains) but they all had one major factor in common: money management and risk management.

Just about every market wizard refers to position sizing as a major part of the “holy grail” of trading. Van Tharp (also featured in Market Wizards) coined the phase in the first edition of his book but he only realized that money management was the holy grail after studying and speaking with hundreds, if not thousands of very successful traders. Tharp’s Book, Trade Your Way to Financial Freedom, is a must read if you would like to understand position sizing and expectancy and learn more about understanding “you”.

The Holy Grail of Trading:
Understanding you and combining that with sound money management rules. Conquer these two entities and you will be successful beyond your wildest dreams!

Filed Under: Education, Expectancy, Position Sizing, Psychology, Subconscious
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