“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.
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.
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.