Position Sizing

The most important part of any trading plan is “How Many Shares do I buy”?
It’s frequently the most overlooked. In the last post I talked about clusters and it’s not what retail traders want to hear I know. Clustering is real and needs to be taken into account in your plan and preparation.

In this entry I just want to get across the calculation and will save the rationale for another day. If you bet 20% of your account in any one trade a cluster of 5 poor trades will take you out. In practice two bad trades will end the game as 40% drawdown will leave your decision making in a mental mess.

The book “Market Wizards” was written about 20 years ago. In the book a futures trader famously said that anyone betting more than 2% of their cash on any one trade is a “Gunslinger”. In practice as you will see I recommend that you use 1% of your account size as the maximum loss.

For the first example today I will use my old friend Dart. The share made an inverted head and shoulders reversal in the last year with a target of 3 pounds from the pattern. It went to 3.05. Since making its target the share has pulled back and “kissed” the neckline of the head and shoulders pattern. That’s normal and I would expect even the strongest of shares to show this phenomena. The move to 3 pound was featured here a few months ago.

The London market has broken up and Dart has excellent fundamentals as defined by the VectorVest metrics RV and RS. The share is trading a discount to the VectorVest value by a third. It’s an undervalued share that’s aggressively growing earnings, safely. The share is presently on a hold recommendation.

Let’s assume I wish to buy at the open on Monday morning which is the same price as the close on Friday the 6th June 2014. That’s a price of 2.82 pounds.
I will use the VectorVest calculated stoploss of 2.65 pounds.

I will assume that I have 25000 pounds in my trading account. Just round up the account size or round down to suit your circumstances.

My maximum risk is 2% of that which is 25000 * 0.02 = 500 pounds.

The Risk per share bought is the purchase price minus the stop loss which is 2.82-2.65 which equals 0.17 pounds. This Risk per share is UNIQUE to each trade. Some trades will require a large percentage stop and some like this trade will have low percentage stop. The stop needs to be placed at the VectorVest defined level which is well out of traffic. Saying that the trade is risky and using a tight stop is tantamount to throwing your money away. You will go broke in a sea of stop loss violations.

Let the number of shares be N
The simple equation is as follows.
N * (risk/share) = 2% of Account size
N = 2% of Account size/ (risk/share)
N= 500/0.17 =2900 shares.

This means the exposure is 2900 * 2.82 = 8178 pounds

This is on the high side for a 25000 pound account although the risk is still at 2%. I recommend that you don’t use any more that 10% of your account in any one trade and thus risking 1% on any one trade is more appropriate here.
If the maximum risk was 1% then the equation is as follows.

N = 250/0.17 = 1470 shares.

Let’s do another example and in this case I will use Shire. The share has excellent fundamentals and recently has broken above a 1 yr high. Shire is on a buy recommendation and much undervalued in a London market that’s rising.
Again assume a 25000 pound account.

Maximum risk= 2% of the account size = 500 pounds
Buy in price = 35.70
VV Stop price = 31.50
Risk per share = 4.20
N= 500/4.2 = 120 shares
Exposure = 120 * 35.70 = 4284 pounds.

At the end of each month as your account grows then the maximum risk (2% of account size) grows. This means that you can trade bigger positions as your account swells but never put any more than 2% of your account at risk.
David Paul
June 8th 2014

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