Stock Trading 101: Learn to Manage Risk with Position Sizing

“If you learn why people lose and thereby control losses, profits will follow” 

 

The above quote comes from the book:  What I Learned Losing a Million Dollars by Jim Paul. The premise of the book is that while there are many ways that people win in the stock market, there are only a few ways that people lose, therefore, rather than study all the disparate “winning systems,” we should seek to understand the small number of ways that market participants lose money and avoid repeating them. It’s a great book and it got me thinking about all the conversations I’ve had with retail traders and investors and how so very few of them talk about their trading plan and how they manage risk…. Guess what! Having no plan and not understanding how to manage risk are two of the ways in which market participants lose money! 

Managing Risk Through Position Sizing:

Managing risk through position sizing is a strategy that I have found to be somewhat common among successful traders. It is the strategy that I employ and it involves defining the risk before you put on the trade.

To illustrate how this works, I’ll use a chart of Bank of America (BAC) that was recently posted by @ATMcharts over on Stock Twits:

BAC Chart.png

I chose this stock as an example because I like the current set-up. In fact, there is a good chance I will take a position next week. So, let’s presume the stock is trading at $18 and I’m about to take a position. What do I do first?

  • I go to my trading plan, which says: Determine the maximum dollar amount to risk for each and every trade & risk no more than 1-2% per trade.

So how do we figure out the “maximum dollar amount to risk for each and every trade?” We start with our total portfolio. Let’s say our entire portfolio is $50,000.

  • If we have a $50k portfolio, and we are putting on 1% risk in the $BAC trade, that means we can risk a maximum of $500 on the trade (1% of $50k = $500)
  • If we want our stop to be at $16.49 which is the 200 DMA on the above chart, then our risk is $1.51 per share ($18 purchase price minus our stop at $16.49)
  • In order to figure out how many shares to buy, divide $500 (our maximum risk) by $1.51 (money we can risk per share) = 331 share purchase
  • 331 shares x $18 per share = $5,958 position size
  • If this trade goes against us, the most we can lose is 331 shares x $1.51 per share = $499.81 or  just under 1% of our $50k portfolio.

The cool thing about this strategy is that you can take on a larger position, with the same amount of risk, by using a tighter stop:

  • We are still buying $BAC at $18 and our risk is still 1% or $500. But this time we see support at $17 and we don’t like it if it breaks support. So we set our stop at $17. Our risk is now $1 per share.
  • Shares to buy: $500/$1 per share risk = 500 shares
  • 500 shares x $18 = $9,000 position size
  • If this trade goes against us, the most we can lose is 500 shares x $1 = $500 or 1% of our portfolio (same as above).

So there you go. You now have a plan, you can manage risk, and you understand how to size your positions. You can now protect yourself from the large swings that blow up trader’s accounts like Jim Paul describes in his book.

if you like this concept and you’re looking for additional information, I suggest The 5 Secrets to Highly Profitable Swing Trading by @ivanhoff – he dedicates an entire chapter to managing risk through position sizing.

Happy Trading!

Disclosure: I have no positions in any of the stocks mentioned in this article but I may take a position in BAC in the next 48 hours.

 

5 thoughts on “Stock Trading 101: Learn to Manage Risk with Position Sizing

  1. So essentially you segment your trades as in you only spend $6000 on one position at a time and risk $500 of that which is 1% of your total portfolio $50000. The way you wrote the article, I thought you were spending all $50000 on BAC.

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  2. Thanks for the article, Dave. I like the idea of a predetermined stop to protect the account. And your formula for calculating a stop will be my new method. However, I’ve used stop protection and it sure saved my bacon but one time the stock bounced back up right after I hit my stop. How can I avoid this in the future? Are there some indicators to watch like volume, fib, etc that would indicate a reversal is imminent? Thanks again,

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    1. First let me comment globally, I don’t concern myself with something that happens “one time” or happens rarely. Winning trading for me is about exchanging small losses for big wins. In other words, knowing what I can lose going into the trade and accepting it when it happens (and it will happen often). Having a risk management plan and sticking to it (even when weird things happen) has been a key to success for me. If my stop gets taken out and the trend reverses, I can always get back in. And if the stock runs away without me, it’s confirmation that I’m finding good set-ups; so I just look for another opportunity.

      To specifically answer your question, one way to avoid this is to trade closing prices. In other words set your stop for a close under $X. Also, one way to mitigate the risk you describe is to ensure that you are trading liquid stocks – stocks with large trading volume and a large float. It’s much harder for stops to be taken out when the float is large and there is liquidity.

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