Rookie Corner : The Mechanics X
This week in the Rookie Blog we are going to go over the second tool we will use to accelerate our efficiency in trading. Last week we looked at a spreadsheet that helps us figure out our Risk/Reward as well as our Entry, Exit and Target prices. Did you find this tool helpful? It most definitely saves you time and that is one of the major reasons that some folks get into trading and that is to be able to get their time back. Before we got into the spreadsheet we needed to understand how to find those points of data manually so that we could fully understand the spreadsheet to ensure that is was giving us legit data. We now need to do that with the next tool as well. If you think about it for a moment you will realize that a tool is only as good as our understanding of its use. If you had a hammer but you didn’t know what a nail was would the hammer do you much good? That is the same way we need to think about our trading tools as well.
So this week we are going to look at a tool that performs possibly the most important function in trading and that is position sizing. Why is position sizing so important? Well, let me explain with an interesting conversation I just had with one of my fellow traders. This individual wrote to me to ask about a specific equity that just got crushed in the market recently and after doing a little digging this individual found out that this equity got crushed because of a change that a related company actually made. I was then asked how the “collateral damage” could have been avoided or at least minimized. There was some musing about the different stop loss order types and whether that may have saved the beat down of one’s position. I told this individual that the event that caused this issues was a black swan event and that although these events are rare and hard to predict that they do on occasion happen and that the only way to really protect one’s self is through good position sizing. Good position sizing must be the cornerstone of any trading plan for anyone who wishes to remain in this business for any length of time without suffering catastrophic losses at some point.
Having said all that let’s take a look at how we figure out position sizing for ourselves. The first thing we need to do is to determine what the max loss is that we are willing to take on any one trade. This usually comes in the form of a percentage of the overall portfolio. I have talked about using no more than 1% of your portfolio if you are a beginner and if you choose to be more conservative then 0.5% is good too. Now, let’s say we have a $10000 portfolio and we are willing to risk 1%. That comes out to a max risk on any one trade of $100. Now, that we know the most we can lose then we can back engineer the number of shares in the trade. Let’s say we buy XYZ stock at $50 and we place our stop loss at $49. Then by simple math, we can figure that if we are risking $1 per share then we can buy 100 shares. Pretty easy right? You would be surprised at the number of folks who are unwilling to do even that simple math to save their portfolio. Now, if you are an options trader then you know that 1 option contract equals 100 shares and so you can extrapolate that number easy enough.
So to recap,
Buy XYZ at $50
Stop Loss at $49
Max risk per share = $1
Therefore our max risk on any one trade is $100 so we can buy 100 shares and still be within our rules.
Ok, so now that we know how to figure out position sizing manually let’s look at our tool and see if we can make sense of it and see if it helps us be more efficient.