Author: JUSTIN NIELSEN
Source
Want to be successful in the stock market? Sound portfolio management rules are a crucial step.
X
In particular, you need to make sure that one trade doesn’t take on so much risk that it sinks your portfolio.
But what happens when a logical level for your stop loss is larger than you would like? Adjust your position size. That way the larger risk for the trade doesn’t turn into a larger risk for your portfolio.
Portfolio Management And Dollars Risked Per Trade
First, you need to have a set amount you are willing to risk per trade. Say you’re willing to risk 1% of your portfolio on each trade. For a $100,000 portfolio that works out to $1,000 of portfolio risk. Sure, an unforeseen gap down in price could make you lose more. But for the most part, being disciplined in your portfolio management means those cases will be rare.
Then, consider the risk percentage for the trade. Investor’s Business Daily often suggests a 7% or 8% automatic sell from your purchase price. It’s an easy portfolio management tool for reducing risk. If you buy a stock at 50, your stop triggers at 46 or 46.50.
Next, determine your position size. Simply divide your dollars risked by your risk percentage. That gives you a position size of $12,500 ($1,000 divided by 0.08). In terms of a weight for your portfolio, that’s 12.5% for a full position. This is our logic behind using eight positions for a fully invested portfolio and the model used for IBD Leaderboard. It’s simply the way the math works out.
Adjusting Position Size
Not all markets are created equal, nor is each trade. In a strong uptrend, you might consider getting more aggressive. You might be willing to risk more dollars per trade because the reward potential is greater. You may even use margin to juice up your returns. When things are weak, you may adopt a conservative stance. Consider reducing the portfolio risk to just half a percent per trade or less. It’s also smart to do less trading in an unfavorable environment.
There are also situations where allowing for a larger loss on the trade makes sense. What if you identify a strong stock that typically gets support at its 10-week moving average and at your entry, the 10-week line is 10% away? What do you do? You can adjust your position size.
In this case, $1,000 risked will lead to a $10,000 position size ($1000/0.10). You’re taking on a little extra risk for the trade, so you adjust your position size down from 12.5% of the entire portfolio to 10%.
Of course, as with any portfolio management decision, consider the trade-offs. If the stock is truly a big winner, you will have less invested. But that might be better than passing up the trade entirely. Or even worse, your 8% loss triggers and then you watch the stock bounce off the 10-week line and go on a winning streak without you.
Alteryx Stock Example
Let’s consider an example for practice. Alteryx (AYX) is in the computer software database field. In a world of data and the necessary analysis that comes with it, Alteryx offers platforms that ease the process. In 2019, MarketSmith pattern recognition identified a base breakout (1) on Jan. 7 at 67.50. If you got in right at the buy point your 8% stop was at 62.10. In its 119% run over the next nine months, it never triggered your stop.
But what if you bought it above that buy point? We often use a 5% buy range above the buy point. Let’s say you bought Alteryx stock at 70.88 the next week (2) right at the edge of the buy zone. That would put your 8% stop at 65.21, just 3.3% below the breakout. A little tight.
And if you wanted to use the 10-week line as your stop, that was 14% away at 60.88. Why use the 10-week line? Many of the best performing stocks will find support at that level during their moves. Taking a step back to the weekly chart, you can end up riding a big winner for the bulk of its move if you hold it as long as it closes above the line.
So if you decide to use the larger risk percentage of 14%, how do you adjust the position size? A little math ($1000/0.14) brings the position down to $7,143. Even if you take the larger percentage loss on the trade, your portfolio will only take the same hit of $1,000.
How Did It Play Out?
A larger risk percentage made a big difference if you bought at the top of the 5% buy range. You might have survived the test down to 65.34 in February (3). But an 8% stop would have knocked you out at the beginning of March (4). If you were using the looser stop of 60.88, it didn’t trigger. And while Alteryx stock fell below the 10-week line, if you waited until the close of the week, it got support and was right back above it.
Another test of the 10-week line occurred in June (5) and by that time a sizable cushion was in place. When the decisive close below the 10-week line did happen (6), the move was truly over. A base of over 40% followed and a brief attempt at overtaking the old highs in February didn’t last. Even selling at the close of the week, left you with nearly a 60% gain.
However, there is a warning on the other side. You might come up with a risk percentage that is very small, 1% or so. The math will tell you that you can have an outsize position of 30% or more. Don’t do it as a starting point. If you are going to have a concentrated position bigger than 20% or more, it’s usually something to achieve through appreciation in your stock and possibly adds along the way. Not as a starting point.
IBD Live Position Size Calculator
Download The Calculator
| Dollar amount you want to risk on the trade: | $1,000 | Dollar amount you want to risk on the trade: | $1,000 | |
| Entry price: | 70.88 | Entry price: | 70.88 | |
| Stop price: | 65.21 | Stop percent risk: | 8.0% | |
| Dollar amount of position: | $12,501 | Dollar amount of position: | $12,500 | |
| Number of shares: | 176 | Number of shares: | 176 | |
Proper risk management is the foundation of any successful trading plan. IBD traditionally uses a maximum stop loss of 8% on any given trade.
An alternative is to determine the portion of your overall account you want to risk on any given trade and then place a stop near a reasonable area, such as the 10-week moving average. A decisive weekly close below the 10-week line is one of the best sell signals for intermediate-term trading.
Risk no more than 1% of your portfolio on a single trade and even less in volatile markets. Your position size as a percentage of your portfolio can range from 10% to 15% in healthy markets. Avoid excessive position sizes when your stop is close to the entry price by reducing the dollars risked.
This means given a $100,000 account, your maximum loss for any single trade would be $1,000. In difficult times, you would want to risk much less.
There are two versions of the calculator: The first requires you to input the dollars risked, current stock price and stop-loss price. The second requires dollars risked, current stock price and the stop-loss percentage as a positive value. Both determine the dollar size of the position and number of shares to purchase.
This article was originally published May 7, 2020.
YOU MIGHT ALSO LIKE:
SwingTrader Has A Position Size Calculator: Here’s How It Works
Start Building Your Watch List Now: Top Stocks In Leaderboard Today
Swing Trader Strategy Basics For Short-term Trades
How To Select, Buy And Sell Top Growth Stocks: The 7 Most Important Words On Wall Street
The post Calculating Position Size For Portfolio Management appeared first on Investor’s Business Daily.