Position size, or the number of shares you purchase, is a subject often overlooked by many traders. How many of us have an actual method that we use and stick to, or are we arbitrarily using the same number or percentage with each trade? Today, Chuck LeBeau, who is soon to be inducted into the “Traders' Hall of Fame," an INO TV author, and exit strategy specialist has stopped by to introduce a positioning method that can be introduced into any portfolio.
Read his strategy for determining position size below and leave a comment to let Chuck, and other Trader's Blog readers, know what you think. Also, check out Chuck's newest endeavor at SmartStops.net.
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Deciding how many shares to buy on each trade is easy – once you know how!
How many shares should you buy when you enter a new position? Most investors are creatures of habit and buy the same number of shares each time, usually some nice round number or dollar amount. Others are a bit more sophisticated and invest a certain percentage of their portfolio value. If your portfolio is $100,000 and you add a new position you might invest $10,000 or 10% of your account size or maybe you just buy your usual position of 100 shares. If any of these procedures sounds familiar to you, you need to learn more about how to correctly determine the correct number of shares to buy. The pros refer to the correct procedure as “position sizing”.
The easiest explanation is to give a simple example. Here is how position sizing should be done: Measure the total value of your portfolio and then decide on a percentage of that portfolio that you are willing to risk losing on the new position. Let’s say that your portfolio is worth $100,000 and you want to keep any possible loss to 1% or less. (If you risk more than 2% on any transaction the pros would consider you to be a wild and crazy “gunslinger.”) The plan is, you intend to buy shares of XYZ at the current price of $25 per share. Now some of you may jump ahead and figure that if your risk is to be limited to only 1% you can buy only 40 shares (40 X $25 = $1,000) but that’s wrong!
The correct procedure is that before you make your purchase you need to figure out where your exit is going to be if you are wrong and the stock goes down. You need to have this loss point clearly in mind before you make your purchase. Let’s assume that you decide that your exit will be at $21 if the stock ever drops that far. Now you know that your risk per share is exactly $4 and you divide your risk limit of $1,000 by $4 and learn that you can buy 250 shares instead of only 40 shares. If the stock goes up, you will make much more with 250 shares than you would have with only 40 shares. But the big surprise here is that in either case your risk has been limited to $1,000.
As you can see, the math is easy, but the big question is how to figure out exactly where to sell the stock if it goes down more than it should. There are a lot of great stop-loss methods and tools available, like the highly intelligent risk management tools developed by SmartStops.net, which tell you on a daily basis exactly where any stock should be sold to avoid the probability of large losses.
Controlling risk is a two-step process. In volatile high-risk markets you limit the risk by trading a much smaller position size. In quiet and orderly markets you can take on a much larger position size. In both cases the accuracy of the final calculation will depend on determining a logical exit point that protects capital without being too close and getting stopped out by random price movements.
Chuck LeBeau
SmartStops.net
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Chuck LeBeau is Director of Analytics at SmartStops. He is considered to be the leading authority on exit strategies and has served as a consultant to many of the world’s largest financial institutions including a central bank and the world’s largest sovereign wealth fund. He has been an investment professional for more than 45 years and has authored many articles about investing as well as a classic book on technical analysis “Computer Analysis of the Futures Market” which has been published in seven languages. His new web site at www.SmartStops.net is the leading provider of effective, easy-to-implement risk monitoring solutions for investment professionals and individual investors.
Chuck will be receiving the 2010 “Trader’s Hall of Fame” award this month at the Traders' Library Trading Forum in Chicago. This prestigious award will honor his lifetime achievements in trading and in educating investors on the importance of exits.
A good example of why bet size is important can be sean in beta slipage in terms of inverse & leverage ETFs when holdings are adjusted @ the end of trading day
I have not traded with a stop for years because it does not fit my method & personality. Not everyone should use them. I control my risk by position size & using options. Iam a position trader & will buy deep in the money options & or leaps with aprox a delta of 90 & will exit them when my method tells me to or roll them over when there is less then 3 months left to exploration. Will use OTM puts if I think a crash will occure.
A verry successfull method over the last few years that does not use stops is to rebalance an index fund @ regular intervills i.e., re,adjust every 6 months to hold 50% cash & 50% SPY in your accuont. That way you are buying high & selling low. Of course there are many methods for rebalancing that can be used other then 6 months. Of course this method is not for everyone & is not without risk.
An investor ehould understand that there can be a lot of slipage when using a stop i.e., the crash of 87. Low volitility leads to high volitility & thinking low volitility can reduce slipage can be dangerous.
I think the basic concept regarding controling risk by position size was well done by everyone above. An individual can still limit risk & have a method that gives him an edge without using stops. Of course the method must fit ones personality.
so how can i apply this to forex trading? cos i'm not exactly sure
Thanks, Kenny and congratulations to Chuck on his Award !!!
I'm sure this article will be helpful to many traders.
Trading without stops is like driving without brakes. Who would do something crazy like that? I did and got my head handed to me. No more!
I learned the hard way.
Remember,there are only 4 outcomes to any trade.
1. Big gain
2. Little gain
3. Little loss
4. Big loss
Decide where the little loss is acceptable and then you won't get caught with the BIG ONE.!!!
Is (almost) everyone missing the point of the article? It addresses one method of how to determine a position size. The stop loss point is part of the equation. The process described is a bit too simple if you maintain a significant cash position and/or options are an important part of your portfolio. The equities portion of your portfolio needs to be considered a separate entity when using this.
Here is the same thought process, but put a bit simpler, and is the only way to start the trade:
The very first decision a trader should make is how much money he is willing to loose on the trade. Period.
The next decision is were to put the stop. From there it is easy to determine the amount of shares, since we know the current price.
Amateur's do not think in terms of how much they are willing to loose, they only think of how they will spend all of their "winnings".
Good Luck
Allowing for a four Dollar loss on a $25 trade seems excessive. I do get the point that not all your trades will decline at the same time. But unfortunately markets, on occasions, do fall in tandem. If this does happen, then by my calculation, a 16% loss is a possibility. I am new to the game, and I have generally been using a 5% stop-loss, and I've got stopped out a few times. Am I missing something?
Since a large loss limit will simply reduce the number of shares in the trade, it really doesn't matter how big the loss limit is. Giving a trade a wide loss limit may give the trade more time to achieve its profit potential. OTOH, it may indicate a lack of analysis, understanding or conviction in the trade.
A large loss limit will often make it difficult to enter the trade since a typical 3:1 reward:risk will be hard to achieve.
Good guide line. Same method of position control as Van Tharp. I will take one step further to pick up only the stock/ strategy combination with profit factor >3. Profit factor is calculated by total gain of the winning trades divided by total loss of losing trades over the last 10 trades. If you don't have enough trades, use an entry/ exit strategy to simulate.
Using a 3X gain potential has more to do with risk/reward, and therefore determining whether you want to make the trade, rather than risk management.
I calculate r/r by dividing the potential gain by the loss limit for the current trade rather than any average of gains or losses since they really don't apply to the current trade.
Definitely worth two reads... interesting perspective.
Professional traders focus on risk management. Amateur traders focus on gain potential. Amateur traders tend to be greedy and focus on how much money they stand to make on a trade if only the stock goes up x%. Professional traders tend to be fearful and focus on how much money they stand to lose on a trade if the stock drops x%. They then go about engineering methods to mitigate their risk.
Although a discussion of the total number of positions to be held in a portfolio was omitted (this is very important for overall portfolio risk management), and it appears that Chuck is presenting a commercial for his stops service (may not be a bad thing if any traders are placing trades without stops; they need something and Chuck's service is certainly better than nothing), this is an good intro to the sometimes complex, but always vital, subject of position sizing.
Van Tharpe would be proud!
Good article. Could have gave market club members a discount for the servie.
I have always said the biggest difference in a professional trader and a "retail" trader is that pros never, ever, ever trade without a stop. And retail traders......well.
Great post Kenny!
Trading with no stop is like rock climbing without a safety rope or riding a motorcycle without a helmet.
Who rides a harley or a custom with a helmet?