Whether you are investing or trading, proper trade size is a vital component. If your size is too large, you are risking too much per trade and you have the potential for substantial losses if the trade doesn’t work out. Conversely, if the size is too small, even when you hit a big winner, the reward amount for your bottom line is too small to really matter. I am going to give some rules that work very well to determine the appropriate size of the trade. It involves some thinking that I imagine a lot of people just don’t do. This method can be used with investments, short-term trades, or even day trades.
The first mistake most people make is calculating how much money they want to make on a trade. They find a stock that they think will go up (I’ll ignore short selling for now for ease of discussion), and then choose a share size on that stock to achieve their desired profit IF all goes well. Actually, all of this is wrong for several reasons. Number one is that the gain is 100% subjective – you don’t know how much or how little will actually happen. That’s right, you may be the smartest trader in the world, but you have absolutely no control over how much a stock could go in your favor. Therefore, it makes no sense to use this fact to really size up your position. The only thing you have control over is your cutoff point or STOP LOSS. This is the maximum dollar amount you are willing to risk losing IF you are simply wrong. So this dollar amount is a key factor in determining the size of a position. This dollar loss should never be more than 3-5% of the total money in your account.
The second thing to consider is the volatility of the stock you are considering AND the volatility in that sector and the market in general. The higher the volatility, the riskier the stock, in general. From this assessment (just a general feeling), you should calculate a stop loss price based on this volatility. The stop should be far enough away that normal swings in price don’t hit it. Basically it should be a price where if you go there you know you are probably wrong and you should get out of the trade to move on to something better. For something one wants to day trade, typically the last 60 minute range can provide a decent sense of volatility. Be sure to avoid using a time where the action is non-feature, which means on average you have a range of 1.5 points in 60 minutes, but right now it’s only 30 cents or 5 points now. If this is the case, it only adds more uncertainty. For something a little longer term, the range of the last week is usually fine and as an investment, you can use the range of the last 2 weeks or months to calculate it. Again, this is just a general idea of what to expect, not an exact science. What we are trying to avoid is risking 30c on a stock that has a range of 3 points every 60 minutes. The odds of him being hit are pretty high, considering he’s only 10% of the total range. In general, the better you are as a market timer, the tighter the stop vs % will be.