by Teeka Tiwari
Position Sizing
The classic mistake I see many investors, new and seasoned alike, consistently make is over-concentrating their capital in a single position.
In the early days of my investing career, I also made this mistake. In fact, there isn't much information out there to tell us how big our positions should be, so we must figure it out through trial and error (probably with a lot of emphasis on error).
So, I'm going to show you the best way to size your positions to save you a lot of the pain and money.
What I've learned from my own investing journey is that our position size must be determined not by how much money we hope to make, but rather by how much money we are willing to lose if we are wrong.
That's a subtle but important distinction.
My 3% Rule
Being wrong is a part of ultimately being right. The key is to make sure that, when you are wrong, you don't lose too much of your equity while you are on the road to being right.
My general rule of thumb is to risk no more than 3% of my starting equity on any individual trade.
Let's assume that you have a $40,000 account. Does this mean that you only put 3% of $40,000 into your trade?
No!
The 3% is the amount you are willing to lose if your stock position gets stopped out.
In order for this technique to work, you must attach a stop-loss to each of your trades.
A stop-loss is used to manage risk, and it is an order you put in with your broker that will get you out of the trade when the stock hits a certain point.
How it Works
Let's work through the above example: 3% of $40,000 is $1,200. That means if our position hits our stop-loss point, our position size is such that we will lose no more than $1,200.
To take this a step further, let's assume that we want to buy a $20 stock and we want to figure out how much to put into this new position.
The first thing we have to do, before we buy a single share of stock, is figure out our stop-loss point. (This is such a critical part of managing your own portfolio that I plan to do an entire article on this subject as part of this series.)
Let's assume that we have looked at the stock and we've chosen a stop-loss point of $17 per share.
Once we know where our stop-loss point is ($17), we can begin to work out how many shares we can buy. To do this, we simply divide the amount we are willing to risk ($1,200, which is 3% of $40,000) by the amount of points of our stop-loss is from our entry price (3 points).
The entry price is $20 and the stop-loss point is 3 points below our entry price, so $1,200 divided by 3 equals 400. So, this tells us that we can buy 400 shares of the stock at $20 with a $17 stop-loss point.
If we get stopped out at $17, our loss on 400 shares (assuming we paid $20 for them) would be $1,200, or 3% of our total starting equity of $40,000.
To Change Your Stop-Loss, Adjust Your Position Size Accordingly
If you want to make your stop point larger, you must adjust the amount of shares you buy.
Let's say you took another look at the stock's chart and decided that you wanted to have a stop-loss point of $15 instead of $17.
All you would do is take the difference between your entry price of $20 and your stop-loss price of $15 (which is $5) and divide that by $1,200 (3% of your portfolio value). This would give you a figure of 240, which means that, if you want to use a stop-loss of $15, the biggest position you could take -- and still be within the 3% rule -- is 240 shares.
This is what I mean when I say that our stop-loss point dictates our position size. You choose your stop-loss point, and your stop-loss point chooses your position size.
