We’ve all been to social gatherings and listened to people brag about having made “a killing” in a specific company’s stock. Sometimes they’ll even say, “I bought a huge position and it soared!”
They usually don’t mention the times they took this kind of risk and instead of making a killing they were crushed and lost a lot of money. Placing too big of a bet on any single position can be a sucker’s game.
TradeStops is an effective antidote to the temptation to place too much of our investment capital into any one stock or sector. One of the features it offers is a Position Size Calculator which is easy to use.
Simply log in to your TradeStops account and in the top header you’ll see the word “Research”. Click on it and you’ll be instantly transported to the page where the Position Size Calculator is found.
Before reviewing the steps in using this calculator we want to share an educational interview with S&A Editor-in-Chief Brian Hunt on how to combine stop losses with the idea of position sizing to drastically reduce risk in your portfolio.
This is a “core” benefit TradeStops offers to help place a “safety-net” under your portfolio. This kind of risk management saves money by limiting losses while conserving the chance for capturing gains.
The interview with Mr. Hunt was conducted by The Daily Crux and was part of an article titled, “The World’s Greatest Investment Ideas: Position Sizing”. Below is a large part of this very helpful article.
The Daily Crux: “Brian, one of the most important things any new investor can learn is correct position sizing. Can you define the idea for us?
Brian Hunt: Sure… Position sizing is an incredibly important part of your investment or trading strategy. If you don’t know the basics of this concept, it’s unlikely you’ll ever succeed in the market. Fortunately, it’s an easy concept to grasp. Position sizing is the part of your investment or trading strategy that tells you how much money to place into a given trade. For example, suppose an investor has a $100,000 account. If this investor buys $1,000 worth of shares in company ABC, his position size would be 1% of his total capital. If the investor bought $3,000 worth of stock, his position size is 3% of his total capital. Many folks think of position size in terms of how many shares they own of a particular stock. But the successful investor thinks in terms of what percentage of their total account is in a particular stock. Crux: Why is position sizing so important?
Hunt: Position sizing is the first and probably most important way investors can protect themselves from what’s known as the “catastrophic loss.” The catastrophic loss is the kind of loss that erases a large chunk of your investment account. It’s the kind of loss that ends careers… and even marriages. The catastrophic loss typically occurs when a trader or investor takes a much larger position size than he should. He’ll find a stock, commodity, or option trade he’s really excited about, start dreaming of all the profits he could make, and then make a huge bet. He’ll place 20%, 30%, 40% or more of his account in that one idea. He’ll “swing for the fences” and buy 2,000 shares of a stock instead of a more sensible 300 shares. He’ll buy 20 option contracts when he should buy three. The obvious damage from the catastrophic loss is financial. Maybe that investor who starts with $100,000 suffers a catastrophic 80% loss and is left with $20,000. It takes most folks years to make back that kind of money from their job. But the less obvious damage is worse than losing money… It’s the mental trauma that many people never recover from. They can get knocked out of investing forever. They just stick their money in the bank and stop trying.
They consider themselves failures. They see years of hard work – as represented by the money they accumulated from their job or business – flushed down the toilet. It’s a tough “life pill” to swallow. Their confidence gets shattered. So clearly, you want to avoid the catastrophic loss at all costs… And your first line of defense is to size your positions correctly.
Crux: What are the guidelines for choosing a position size?
Hunt: Most great investors will tell you to never put more than 4% or 5% of your account into any one position. Some professionals won’t put more than 3% in one position. One percent, which is a much lower risk per position, is better for most folks. Seasoned investors may vary position size depending on the particular investment. For example, when buying a safe, cheap dividend stock, a position size of up to 5% may be suitable. Some managers who have done a ton of homework on an idea and believe the risk of a significant drop is nearly non-existent will even go as high as 10% or 20% – but that’s more risk than the average investor should take on. When dealing with more volatile vehicles – like speculating on junior resource stocks or trading options – position sizes should be much smaller… like a half a percent… or 1%. Unfortunately, most novices will risk three, five, or 10 times as much as they should. It’s a recipe for disaster if the company or commodity they own suffers a big, unforeseen move… or when the market in general suffers a big unforeseen move.
These big, unforeseen moves happen with much greater frequency than most folks realize.
Crux: Can you explain how the math works with position sizing?
Hunt: Yes… But first I need to explain a concept that goes hand in hand with determining correct position sizing: protective stop losses. A protective stop loss is a predetermined price at which you will exit a position if it moves against you. It’s your “uncle” point where you say, “Well, I’m wrong about this one, time to cut my losses and move on.” Most people use stop losses that are a certain percentage of their purchase price. For example, if a trader purchases a stock at $10 per share, he could consider using a 10% stop loss. If the stock goes against him, he would exit the position at $9 per share… or 10% lower than his purchase price. If that same trader uses a stop loss of 25%, he would sell his position if it declined to $7.50 per share, which is 25% less than $10. Generally speaking, a stop loss of 5% is considered a “tight stop”– that is close to your purchase price – and a 50% stop loss is considered a “wide stop” – that is a long way from your purchase price
Combining intelligent position sizing with stop losses will ensure the trader or investor a lifetime of success. To do this, we need to get familiar with the concept many people call “R.”
Crux: Please explain…
Hunt: “R” is the value you will “risk” on any one given investment. It is the foundation of all your position-sizing strategies. For example, let’s return to the example of the investor with a $100,000 account. We’ll call him Joe. Joe believes company ABC is a great investment and decides to buy it at $20 per share. But how many shares should he buy? If he buys too many, he could suffer a catastrophic loss if an accounting scandal strikes the company. If he buys too few, he’s not capitalizing on his great idea. Here’s where intelligent position sizing comes into play. Here’s where the investor must calculate his R. R is calculated from two other numbers. One is total account size. In this case, it’s $100,000. The other number is the percentage of the total account you’ll risk on any given position. Let’s say Joe decides to risk 1% of his $100,000 account on the position.
In this case, his R is $1,000. If he decides to dial up his risk to 2% of his entire account, his R would be $2,000. If he’s a novice or an extremely conservative investor he might go with 0.5% or an R of $500. Joe is going to place a 25% protective stop loss on his ABC position. With these two pieces of information, he can now work backwards and determine how many shares he should buy. Remember… Joe’s R is $1,000, and he’s using a 25% stop loss. To calculate how large the position will be, the first step is to always divide 100 by his stop loss. In Joe’s case, 100 divided by 25 results in four. Now, he performs the next step in figuring his position size. He then takes that number – four – and multiplies it by his R of $1,000. Four times $1,000 is $4,000, which means Joe can buy $4,000 worth of ABC stock… or 200 shares at $20 per share. If ABC declines 25%, he’ll lose $1,000 – 25% of his $4,000 – and exit the position. That’s it. That’s all it takes to practice intelligent position sizing.”
With TradeStops you can easily set up trailing stop loss alerts to fit your risk tolerance and investment goals. Also the Position Sizing Calculator helps you know the amount to invest in any one position.
Just click on “Research” on the top of the TradeStops home page. Then start filling in the blanks. Begin with the stock or ETF symbol, trade type (Short or Long), the entry price and the total investment assets. Whether you’re interested in a more volatile stock like Tesla Motors (TSLA) or a steady-Freddy dividend stock like Automatic Data Processing (ADP), position sizing is always an important part of your financial plan’s risk management strategy.
Next choose your “Risk %”. This is the percentage of your investment assets that you’re willing to lose in a single investment position if your trailing stop loss limit is reached and you receive an alert.
Last choose that trailing stop % and hit the “Calculate” button. You’ll see in to your right the number of units (shares) you’ve chosen to own, the dollar amount of your invest-able assets that you’ve chosen to invest in that particular position and the dollar amount that’s at risk if you’re stopped out.
That’s how TradeStops helps you to be a careful investor who employs one of the best formulas for managing your investment risk while aiming for outstanding profits.