The Importance of Proper Position Sizing Your Stock Trades
The novice trader does not set stops and does not practice position sizing techniques. He or she trades a stock based on the "feeling" they have. While the novice trader may experience some successes, they will be short lived when eventually one trade turns against him or her. Eventually the novice trader will see a trade in the red and end up holding on to a loss for too long.
What is position sizing?
Position sizing is the amount of money you have invested in a stock or option.
Proper position sizing is important to the success of a trader. Many of us figure out only in hindsight that we should have put more money on that stock that doubled or less money on the stock that fell 20%. We often think to ourselves, "if only we had doubled up and bought more of that stock or if only we had bought less of that stock".
While position sizing won't help you predict the future, it will help you control the amount of money you have at risk in the market. Risk tolerance differs from person to person. Some people have higher risk tolerance than others and people like myself would rather not have large drawdowns on the account.
How do I size my position?
The best way to determine how much of a stock you can buy is to think in terms of how much you are willing to lose on a trade.
What does this mean?
If you buy 100 shares of a $3 stock that does not mean you are risking $300. You could set your stop at $2, which means if the stock hits $2, you will sell the stock. The end result is a loss of $100.
Purchase: $300 (Buy 100 shares of a $3)
Stop: Set at $2
Stock hits $2 and you sell the stock
Loss of $100
Here is another example, suppose you buy 100 of a $10 stock. This means you put out $1,000 on the stock. You set your stop at $8, so you are effectively risking $200 on that trade.
Purchase: $1,000 (Buy 100 shares of $10)
Stop: Set at $8
Stock hits $8 and you sell stock
Loss of $200
Yes, the stock could hit the stop and you could be out $200 and then you could see the stock go back up to $10. Alternatively, you could see the stock fall to $8 and then continue to fall to $5. If you didn't have a stop at $8 you basically lost $500 on that trade.
This is precisely what happened to many stocks in 2009. Whereby stocks like Bank of America (BAC) fell from $40 to $20 to $10 to $5. Even if you held on to the stock from 2008 at your purchase price of $35, you still would not see a profit in 2013.
Think in terms of how much you are willing to lose on a single trade. If you do that, you will not want to try to hit home runs on every stock trade.
Labels: Finances, Pro Stock Trading Tips