Stock Position Sizing Calculations
There are a number of sources to obtain a position-sizing calculator on the internet. However, it is important to understand the rationale for the position size calculations.
One of the most important yet most overlooked aspects of investing is position sizing. Whenever you buy shares of stock, you are encountering a risk of loss. Have you thought through the risk you are incurring? Position sizing is a method to control how much you are willing to lose on each investment you make.
Dr. Van K. Tharp performed an experiment on position sizing in his book Trade Your Way to Financial Freedom. He tested five position-sizing methods where the only variable was how the size of the position was established. In this study, he found that those who based the size of their position on the percent risk or the volatility of the stock fared much better than those who used the three other methods. The percent risk model looks at how much you are willing to lose on each trade to determine the size of your stock position.
Before describing how to calculate your position sizes, let’s look at how a few relatively small losses can add up to a dramatic reduction in the size of your portfolio. Assume you have a $100,000 portfolio. Not every trade is a winner. If you were to experience five losing trades in a row, risking only 4% of your total portfolio on each trade, your portfolio would fall to $81,537. Ouch, that hurts. Had you risked 5% on each trade, your portfolio would be worth $77,378. Some investors are willing to lose 10% on a trade. If they had five losing trades in a row, their portfolio would have plunged to $59,049.
Stock position sizing revolves around three factors that are under your control. First, diversification is a widely used technique to reduce risk. One way to diversify your portfolio is to spread the risk across several stocks. For individual investors, think about the amount of time you have to monitor your stocks, reading press releases, listening to conference calls, reading your companies SEC reports, etc. A good rule of thumb is to spend at least one hour a week reviewing your current stocks. This does not include the time you should spend evaluating new stock investing opportunities. As you can see, it takes a substantial commitment of time to keep up with your portfolio. There are a number of methods to diversify your portfolio properly. At a minimum, you should have at least five different stocks. I like to keep about ten in my portfolio, providing the opportunity for sufficient diversification without overwhelming me with too many companies to monitor. The maximum number of stocks you want to hold in your portfolio is the first determinant of the size of your position.
The second factor you should consider is how much you are willing to risk on the particular trade. Again, this can be a percent or an absolute dollar amount. Think of this as what it will take to let you sleep well at night. For example, if you have $10,000 to invest in a stock, you might only be willing to risk 5% on the trade. This number gives you the next number to calculate the size of the stock position to acquire.
Professional investors focus first on the risk of a loss before they concentrate on the return. In other words, they carefully understand what can go wrong and then put in place techniques to mitigate the risk of their position. One technique they use is a stop loss. Before they enter a trade, they know exactly what price they will exit the trade if it goes against them. They might use a specific price based on your analysis of the chart, or they might use a percent based on a volatility determination. Either method is a valid way to establish your stop. The stop you use is the third and final determent of the size of your position.
To determine your stock position size, the steps and calculations are straightforward. We will go through the steps and show some examples to help explain the process.
First, decide how many stocks you want to keep in your portfolio.
If you follow my earlier logic, then you might decide that you only want to hold ten stocks in your portfolio.
Assume you have a portfolio of $100,000. Since you accept my view that ten is a reasonable number of stocks to properly track in your portfolio, you should only invest approximately $10,000 in each stock ($100,000 / 10 = $10,000).
Second, establish how much you are willing to lose on a trade.
To get a good night’s sleep, I am willing to risk 5% on a trade. This gives me the amount I am willing to lose.
Taking 5% of the $10,000 for each stock gives you the $500 you are willing to lose on this trade.
Third, establish your stop.
As mentioned, stops can be set at a specific price based on your reading of the chart, or it can be a percent based on your calculation of the volatility of the stock. Either number is used to help set the size of the position you should buy.
You have set the stop for XYZ Corporation at $13.5.
Determine your buy price.
Use whatever method works for you to decide on your purchase price.
In this example, we are buying XYZ Corporation at 15.
Fifth, calculate the size of the position.
First the formula for those that are interested. Position size = ((portfolio size / # of stocks to be held) * (amount willing to risk)) / (buy price – stop price)
Position size for XYZ Corp. = (($100,000 / 10) = $10,000 per position; ($10,000 * 5%)) / (15 – 13.5) = 333 shares to be bought.
By now, you notice that you are only spending $5,000 to buy 333 shares of XYZ Corporation at 15. That is half of the risk capital you were willing to commit for your stock purchase. This is telling you, you are more risk-averse. Probably a good thing.
The reason for the discrepancy has to do with the variables that go into the calculation. First, you are willing to risk a set percent. Changes in the percent to risk will change the amount you are willing to risk. Next, the stop price will affect the amount you are willing to risk.
Notice a theme. Each variable helps to establish how much you are willing to risk. This is the power of dynamically calculating the size of your position.
What if you were willing to risk 10%
Position sizing is an excellent way to help add trading discipline to your investing decisions. There are several position-sizing calculators available on the internet. The one described here follows the dynamically calculated approach as it allows you to change several factors to establish the best position size for your portfolio.
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