Tuesday, May 19, 2009

A Trader's Best Friend

By Brian Hunt, Editor in Chief, Stansberry Research

Of all the friends in the world a trader can have, one of the most valuable is the concept of position sizing – a strategy that tells you how much money to put into a given trade.

Most great traders will tell you to never risk more than 2% of your trading capital on any one position. One percent is better for most folks. A half a percent is also good.

So here's how the math works...

Let's say you're a trader with a $50,000 "grubstake." And you're thinking about buying Intel at $20 per share.

How many shares should you buy? Buy too much and you could suffer catastrophic damage if, say, an accounting scandal strikes Intel. Buy too little and you're not capitalizing on your great idea.

Here's where intelligent position sizing comes in. Here's where the concept of "R" comes into play.

"R" is the amount of money you're willing to risk on any one position. You can easily calculate R from two other numbers: 1) your total account size and 2) the percent of your account you'll risk on any given position.

Let's say you want to go "middle of the road" with your risk tolerance. You're going to risk 1% of your $50,000 account on each idea. Your R is $500. (If you wanted to dial up your risk to 2% of your account, R would be $1,000.)

OK, so you've already decided you want to put a 25% protective stop loss on your Intel position. Now you can work backward and determine how many shares to buy.

Your first step is always to divide 100 by your stop loss number: 100/25 = 4.

Now, take that number and multiply it by your R: 4 x $500 = $2,000.

So you should buy $2,000 worth of Intel... At $20 per share, that's 100 shares. If Intel declines 25%, you'll lose $500 and exit the position.

That's it. That's all it takes to practice intelligent position sizing.

Now... what if you want to use a tighter stop loss, say 10% on your Intel position? Let's do the math...

100/10 (your stop loss percentage) = 10

10 x $500 (your R) = $5,000

$5,000/$20 (share price) = 250 shares

Tighter stop loss, same amount of risk, same R of $500.

Now let's say you'd like to trade Intel options. You're bullish, so you're going to buy Intel calls. The options you want to buy are $2. Yahoo lists options prices by price per share, but option contracts are for 100 shares... So one of your option contracts will cost $200.

A straight call option position is much more volatile than a straight stock position. So you could set a wide stop loss of 50% on your call position. A wider stop will mean a smaller position size. Take a look:

100/50 (your stop loss percentage) = 2

2 x $500 (your R) = $1,000

$1,000/$200 (price per call option) = 5 option contracts

Different stop loss, different position size, different kind of asset, same R of $500.

You can use the concept of R to "normalize" risk for any kind of position... from crude oil futures to currencies to microcaps to Microsoft. If you're trading a riskier, more volatile asset, increase your stop-loss percentage, decrease your position size, and keep your R steady. That way, you're risking exactly as much money on each of your ideas.

Our examples put R at 1% of your total portfolio size. Folks new to the trading game would be smart to start with 0.5% of their account. That way, you can be wrong 10 times in a row and lose just 5% of your account.

To have the importance of intelligent position sizing drilled into your head over and over again by the best traders ever, read Market Wizards by Jack Schwager. For a fuller explanation of R and intelligent position sizing, read Trade Your Way to Financial Freedom by Van K. Tharp. Both are incredibly important books for traders.

Good trading,


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