Ok here’s something I didn’t understand when I first started getting serious about trading. Your “risk” is not the same thing as your capital, i.e. the money you throw at a stock.
If you’re a buy-and-hold investor, you’re used to thinking about risk as whatever money you have invested. That’s because you’re going to keep your money riding on that one pony until either a) you cash it out at retirement, or b) it cashes you out when the company goes bankrupt.
So when I started reading books that talked about portfolio management, I was really puzzled by how many of them used risk to determine position sizes. For example, you often hear a good rule of thumb is to have each position’s risk be no more than 2% of your account.
Well stupid me, I thought that meant no trade could be more than 2%. I had started with about $5000 to play with, to test this new ‘active trading’ lifestyle. So I quickly did the math: 2% of $5000 is $100. I’d lose most of my money on commissions if all my trades were no larger than $100! So I just ignored this advice as something millionaires use as a rule. Because if you’re a buy-and-hope investor, everything is at risk.
But of course, this is not what your risk should be. At least when it comes to “expected risk” or “defined risk”. If you are using predefined stop-loss points – as you should! – then this risk amount is simply the amount you’re willing to lose on each transaction.
I know this is blindingly obvious to anyone who’s been trading for very long, but it was a crucial point of misunderstanding for me.
So a simplistic but practical way to calculate the size of your next trade is this:
1. Determine how much of your entire portfolio you want to risk on a trade. This should be a pretty constant percentage, not something you make up as you go along. The actual dollar amount will fluctuate with your account size. So let’s say 2% of your account is your maximum loss per trade
2. Pretend you have $10,000 when you add up all the current value of your stocks and the cash sitting in your account. 2% of that is $200. That’s the amount you are willing to lose on a trade before closing it and moving on to something else.
3. So you take a look at a stock, say for example Apple Computer (AAPL). As of this very second it’s trading around $107.62. How many shares should you trade? You need to address your stop loss before you can figure that out.
4. After looking at the chart, for whatever reason, you decide that anything below $97.93 is too low to continue with the trade. Perhaps you decided based on trend lines or Average True Range multiples, or you pick a simple percentage below your entry price. Or maybe your street address is 9793 Apple St. For the purpose of this discussion, it doesn’t matter HOW you came up with your stop loss. But you’ve picked $97.93 as a get-the-hell-out price.
5. $107.62 – $97.93 = $9.69/share you’re willing to lose. Great! So take your total amount your willing to lose, and divide it by the per-share loss you’ve come up with. 200/9.69=20.63983488132095. So let’s round down to be safe, and call it 20 shares. Now go buy ’em! *
Of course, this is expected risk. Nothing prevents the stock from gapping down 20% from one day to the next, and no amount of hopeful stop-loss planning can prevent that. But that’s “unexpected risk”. I’m sure finance majors have official jargon for these types of risk, but I can’t be bothered to look it up.
You can however mitigate against this by not having all your eggs in one basket. Don’t put too much of your capital into any one trade, and don’t put it all into one industry, sector or even market. Diversify! If you’re properly diversified in your investments, only an alien invasion will wipe you out.
P.S. I’ve spent the better part of the last eight years making my day-job website pretty with beautiful photos and compelling client-oriented text. Here I can use the stupidest graphics and swear all I want, because I’m not trying to sell you something. If you don’t like it, draw me an alien and send it to me.
*This is not a recommendation to buy or sell, as is true for everything on this site. As a disclaimer, I recommend you never follow my advice, ever. Or anyone elses. In fact, don’t ever invest. Oh wait, should you follow that advice? Damn, now I’m confused.