Question on Blog:

Hey Chris,

This post is great. It has really helped me to comprehend the concepts of risk management. I had one question though. Do you advocate holding relatively few investments (5-8) or more? I noticed that in the example with the $100,000 portfolio, the amount of capital used on a single position was $4,000. This would equate to roughly 25 positions in all. Do you think it would be smarter to invest more capital in fewer positions if you are only starting out with, say, $5,000-10,000?

My Answer:
What the reader is saying is only true to a certain degree. Let me show you several examples of buying the same stock with a 7%, 15% and 25% sell stop in place with two different size portfolios. The number of shares change but the risk stays the same.

In the first set of examples I will use $10,000 and then $5,000 for the second set of examples. In these examples, I will use the simplified approach discussed by Brian Hunt from my first post. Please note that these examples don’t consider other variables such as slippage, etc. Please read the book by Van K. Tharp to study the detailed models of position sizing. I will also note that it is very difficult to employ this position sizing strategy with only a $5,000 stake. In my own experiences, I only bought one or two stocks when my portfolio was starting out with less than $10,000. Besides, I didn’t know about position sizing ten years ago!

Example #1:
Stock XYZ is trading at $25 per share
Portfolio size of $10,000
Risk Model of 3% per trade (due to a small account)
The stop loss is 7%

Risk will be $300 = ($10,000*3%)
Amount to Trade at 7% stop: $4,285 = ($300 / 7%)
Shares to be bought: 171

Example #2:
Stock XYZ is trading at $25 per share
Portfolio size of $10,000
Risk Model of 3% per trade (due to a small account)
The stop loss is 15%

Risk will be $300 = ($10,000*3%)
Amount to Trade at 15% stop: $2,000 = ($300 / 15%)
Shares to be bought: 80

Example #3:
Stock XYZ is trading at $25 per share
Portfolio size of $10,000
Risk Model of 3% per trade (due to a small account)
The stop loss is 25%

Risk will be $300 = ($10,000*3%)
Amount to Trade at 25% stop: $1,200 = ($300 / 25%)
Shares to be bought: 48

Now I will change the parameters to a 2% risk model with $5000 in the account:

Example #1:
Stock XYZ is trading at $25 per share
Portfolio size of $5,000
Risk Model of 2% per trade
The stop loss is 7%

Risk will be $100 = ($5,000*2%)
Amount to Trade at 7% stop: $1,428 = ($100 / 7%)
Shares to be bought: 57

Example #2:
Stock XYZ is trading at $25 per share
Portfolio size of $5,000
Risk Model of 2% per trade
The stop loss is 15%

Risk will be $100 = ($5,000*2%)
Amount to Trade at 15% stop: $667 = ($100 / 15%)
Shares to be bought: 26

Example #3:
Stock XYZ is trading at $25 per share
Portfolio size of $5,000
Risk Model of 2% per trade
The stop loss is 25%

Risk will be $100 = ($5,000*2%)
Amount to Trade at 25% stop: $400 = ($100 / 25%)
Shares to be bought: 16

Piranha

One of our fellow MSW community members wrote a great article on his blog about position sizing and I wanted to bring it to everyone’s attention:
Risk Management – Position Sizing

His main page can be viewed at:

Trend Following with CANSLIM

Since I am on the topic of blogs, I have been meaning to invite the community to read Jon Tait’s blog, Fickle Trader, someone I have formed an “investment relationship” with over the years. We met on the Richdad forums and have kept in touch ever since (we have some great conversations through e-mail about trading). He may refer to me as his mentor (way too much flattery) but I am sure he will be mentoring many more than I in the future while making (trading) his millions in the market.

Below is another simplified example of a specific position sizing method (for further reading on the subject, visit the book by Van K. Tharp that I mentioned on a recent post titled Sound Money Management Key in Trading:

Example:
Let’s say you have $100,000 to invest and you’re using the 1% risk model to guide your investments. If you’re using a 25% stop loss, you could buy $4,000 worth of stock and risk $1,000 ($1,000 is 1% of $100,000).

In the example above, you placed 4% of your portfolio into the stock and set a 25% stop—risking just $1,000 of your money (since $1,000 is 25% of $4,000).

Some investors use even tighter stops, in the 10%-15% range.

If you’re using the 1% risk model with a 10% stop loss, you could buy $10,000 worth of stock. You have the same dollar amount at risk ($1,000) as the first example – but you’re allowing the stock less room to go down before you sell.
Written By: Brian Hunt

Piranha
p.s. – keep in mind that the markets are closed today!

…Last night, I posted a watch list for the upcoming MSW portfolio which is eager to make its first purchase amid the negative market conditions. We recently screened a stock that we feel confident in placing a “test buy” to determine the direction within this lower priced stock (that is showing strength on big volume). The stock will remain unnamed as the watch list and portfolio is posted exclusively for community members. I never incorporated the strategy of making “test buys” into my philosophy until the bear market of 2001-2002. I would always place my entire stake in a position from the minute it crossed the pivot point, made a new 52-week high on above average volume or pulled back to a key trend-line. Things were great in the late 1990’s and “test buys” were not needed as 75% of the market was headed higher.

In today’s market, especially the start of 2005, we have not seen any leaders or solid industry groups produce multiple stocks that we can purchase. Aside from the few all-stars on our screens in 2005, the general market has been weak and has not presented excellent opportunities as it did in previous years. To determine the strength of the market, you can always initiate a position in a stock that you feel has potential by placing a “test buy” for approximately1/4 to 1/3 the typical amount of shares you would normally buy.

What is the reason for this test buy?

It allows you to measure the market with real money without hurting your portfolio too badly if the trade goes against you. If I want to buy XYZ at $10 but I don’t feel comfortable committing my usual stake or I am unsure if the stock can produce gains in the nasty environment, I can place a test buy. If I usually stake $10,000 for every position that I establish, I can place a test buy for $2,500 and see if I am right or wrong in my analysis. If the stock goes to $12 or $14, I am right and I can look for an additional entry point to place another 25% or $2,500.

If I am wrong, I can sell quickly for a 7% loss and wait until the stock and the general market presents me with another opportunity to re-enter. The loss of 7% on $2,500 is only $175, a very inexpensive insurance policy in the stock market. If I had placed my typical amount of $10,000, I would have lost $700 on the 7% stop. You can see the difference between the two losses and how I can continue to place “test buys” allowing me to determine where the market and individual stocks are headed. I can also get a feel for the market makers, the institutions and the general atmosphere by using real money without jeopardizing large amounts of cash.

If the stock does advance, you won’t make as much profit initially (if you used the entire $10,000) but you can add to the position on a pullback because you have already been confirmed correct with your analysis. When adding an additional position, I suggest that it should be equal to the original “test buy” so you don’t expose yourself to greater losses that could happen if the stock decides to breakdown. Once again, if you are proven right by making further profits, a third position may be established at yet a higher number as long as all indicators are positive (fundamental and technical). Always try to buy a stock on a healthy pullback instead of getting it at the peak of a short run above the pivot point.

Don’t get confused with this strategy:

• When a stock is approaching its pivot point, we try to buy at the precise peak where the line of resistance disappears.
• These additional purchases are happening well past the original pivot so they must be placed carefully and not at the new 52-week high. Another thing, if you like the stock, buy it “at the market” instead of penny pinching with limit buys and the like.

This idea of placing “test buy” usually comes into effect during sideways markets, corrections or bear markets. In a roaring bull market, test buys are usually not needed as most stocks will blow past the pivot point and never look back. Always know the general health of the market, the “main trend or direction.

We will all see how this “test buy” works out.

Piranha

…Let’s start by saying: “You can’t be afraid to take a loss”. The investors that are the most successful in the stock market are the people who are willing to lose money.

Having a strategy and/or a specific philosophy is an excellent starting point to investing but it won’t mean a thing if you can’t manage your money. As I have said a million times: “without cash, you can’t invest”.

Most investors spend far too much time trying to figure out the exact pivot point or perfect entry strategy and too little time on money management. The most important aspect to investing is cutting your losses, 90% of the battle is won by protecting your capital, regardless of the strategy.

Most successful money managers only make money 50-55% of time. This means that successful individual investors are going to be wrong about half the time. Since this is the case, you better be ready to accept your losses and cut them while they are small. By cutting losses quickly and allowing your winners to ride the up-trend, you will consistently finish the year with black ink.

Here are some methods that can help you with money management:

• Set a predetermined stop loss (you must know where to cut the loss before it happens – this will help control emotions when the time comes). A 7-10% stop loss insurance policy is best. Tighten the stop loss range in down markets and loosen the range in strong bull markets.

• Establish smaller positions if your account has had a recent losing streak (the losses may be telling you important information such as a critical turning point, it may be time to sell and get out).

• If you think you are wrong or if the market is moving against you, cut your position in half – this is the best insurance policy on Wall Street.

• If you cut your position in half two times, you will be left with only 25% of the original position – the remaining stock is no longer a big deal as your risk is very low.

• If you sell out of a trade prematurely based on a minor correction, you can always reestablish the position again.

• Initial position sizing plays a big part in money management – don’t take on too big of a position relative to your portfolio size. Novice investors should never use their entire account on one trade no matter how small the account.

• Know when you would like to get out of a position after a considerable profit has been made. Signs of topping could be a climax run, a spinning top or higher highs on lower volume.

• Finally, cut any trade that doesn’t act the way you originally analyzed it to act.

With these guidelines, you will be well on your way to solid money management skills that will help you profit in Wall Street year in and year out. Always remember, you are going to take-on losing trades at least half of the time. This is a tough concept to accept for most novice investors but it a fact. If you don’t cut losses, you won’t be investing for very long as you will run out of cash and the desire to continue to invest.

Piranha