The four essential steps of position sizing in stock trading

HOW TO… DETERMINE THE SIZE OF A POSITION?

You have spotted a great stock and you want to buy. You are in front of the ideal trading set-up and you are decided to pull the trigger…but how many shares?

Position sizing is one of the most overlooked subjects in trading and investing, and yet on the long run it determines a good part of the overall profitability.

Why is a good position sizing method important?

• It gives each trade the same weight in your portfolio, or allows you controlling these weights rigorously

• It ensures that you do not take an outsized risk on a given trade

• It ensures that you won’t go in a trade with a ridiculously small stake

• Controlling the risk at a constant percentage of capital maximizes the odds of growing it. It is the famous “Kelly formula”.

Define the size of the position in 4 simple steps.

Let’s say you want to buy stock XYZ at $15:

STEP 1: Take your total capital you want to use for investing or trading and decide the percentage of this capital you are ready to “bet” (to put at risk) on a given operation/trade. This percentage is typically set between 0.5% and 2%. Normally this percentage is the same for all trades.

For example you have a $10,000 capital; you decide that your risk will be 2% or $200 (2% of $10,000). 

STEP 2: Decide where you are going to place the stop-loss order (see: How to…place a stop-loss order). You apply what you learnt and you set the stop-loss at $14.2.

STEP 3: Compute the possible loss per share: if the trade goes bad, your stop-loss will be hit and you will lose 15-14.2=$0.8 per share

STEP 4: The number of shares that you can buy while respecting the amount of risk equal to 2% of capital is simply derived from 200/0.8=250.

That’s it. You buy 250 shares of XYZ at $15 with a stop-loss at $14.2 and you already did a good job: applying a strict methodology is the first success in trading and investing.

KEEP AN EYE ON LIQUIDITY!

LIQUIDITY IS SENDING A WARNING

The following long term chart presents a simple model of liquidity (the ease with which companies are finding money) showed in red, and the EFA (represents worlwide markets ex-USA, but we could have exactly the same study and conclusions with the SPY). The blue line is a moving average of Liquidity.

On the chart we drew simple divergences at extreme points between Liquidity and the market. Liquidity is leading by some weeks: when the market makes a new high (or low) when Liquidity does not (has already a reversal) then the market eventually reverse.

We have to remind that rising stocks markets have to be fed somehow. If money is plentiful, part of it will find its way into stocks. If money is scarce, current companies and individual's needs come first, and there is no reason why new money should buy existing stocks.  On the opposit, many market participants will have to sell stocks to make cash.

The second chart zooms on the current period and gives evidence of a sharp discrepancy between a falling liquidity and a market still sticking to the highs. 

Not a trading system in itself, but a good help. No conviction of a continuation of the bull market before Liquidity climbs above the blue line. Conversely, every sign of weakness in the market has to be taken seriously when liquidity is trending down. In the current situation and if history is a guide, we will see at best some months of ranging market, with bearish implications if the supports we mentioned in our reviews do not hold.

More studies at www.tradingpulsealpha.com trading advice for beginners