Have you ever wondered how much of a certain stock you should buy? Individual investors can attest that it can be difficult to decide on how much of stock X you should buy for your portfolio. Should you buy £1,000 worth of Unilever(ULVR) or £500 worth of Unilever. £2,000 worth of Coca Cola (KO) or £700 worth. £800 worth of Lloyds (LLOY) or £400 worth. You get the point. Deciding on how many shares to buy in a company can be difficult – you don’t want want to buy too little of a stock you have done your research on as you would like as much of the upside as possible whilst on the other hand you don’t want to commit too much of your capital on a single trade for fear of wiping out your portfolio.
There is a mathematical formula that you can use to determine how much money you should place on any single trade. But before we go into this, you need to understand the idea of position sizing and stop losses. Here I explain them briefly.
Position sizing is a great way for investors to protect themselves against catastrophic loss – a loss so large that it could wipe out your portfolio. A catastrophic loss typically occurs when an investor takes a much larger position size than he should. He’ll find a stock or option trade he’s really excited about, start dreaming of all the profits he could make, and then make a huge bet. He’ll place 15%, 25%, 35% or more of his account in that one idea. He’ll “swing for the fences” and buy 5,000 shares of a stock instead of a more sensible 500 shares. He’ll buy 30 option contracts when he should buy 3. Buy doing this, he risks to losing all the hard work he has done to build a portfolio to the size it currently is.
One great way of getting the correct position size for your stock purchase is by using the concept of ‘R’. ‘R’is the value you will “risk” on any one given investment. R is calculated from two other numbers. One is total account size or the total amount of your portfolio. The other number is the percentage of the total account you’ll risk on any given position.
So if you want to risk 5% of your £10,000 account on a particular stock purchase, your R is £500. If you wanted to increase you risk to 10%, your R would be £1,000. So if you are a conservative investor who is risk averse, you want your R to be low, like 1% as this way you can diversify your positions greatly.
On the other hand, a protective stop loss is a predetermined price at which you will sell out of position if it moves against you. It’s the point you say “Well, I’m wrong about this position, time to cut my losses and move on.” Most people use stop losses that are a certain percentage of their purchase price. For example, if a trader purchases a stock at £50 per share, he could consider using a 10% stop loss. If the stock goes against him, he would exit the position at £45 per share… or 10% lower than his purchase price. A protective stop loss limits the downside when you get a position wrong.
If you combine position sizing with stop losses you can ensure that you will have a successfully run portfolio. By knowing your position size and stop loss, you can know exactly how many shares to buy in a certain company.
To understand how ‘R’ and protective stop losses help you intelligently position the size of your trade , look at the example below.
Say Andy’s ‘R’ is £1000 and has a 20% stop loss in place. The first thing Andy needs to do is divide 100 by his stop loss. So 100 dividend 20 is 5.
The next step which determines the position size is taking the number just calculated – 5 – and multiplying it by R (£1000). 5* £1,000 is £5,000, which means Andy can buy £5,000 worth of stock in the company he has chosen, say XYZ Plc. So if XYZ Plc has a share price of £10, he can buy 500 shares.
If XYZ declines 20%, Andy will lose £1,000 – 20% of his £5,000 – and exit the position. It is really this simple. This is all it takes to practice intelligent position sizing.
Here’s the calculation again:
• 100 divided by your stop loss equals “A.”
• “A” multiplied by “R” equals position size.
• Finally, position size divided by share price equals the number of shares to buy.
If Andy wanted to use a tighter stop loss of 5%, his position in XYZ will be as follows:
• 100 divided by 5 equals 20.
• 20 multiplied by £1,000 equals £20,000.
• £20,000 divided by the same £10 share price equals 2000 shares.
So you can see that using a tighter stop loss with the same R allows Andy to buy a larger number of shares, while risking the same amount of his total account; £1,000.
As seen from the example above, you can use the concepts of position sizing and stop losses to determine how much of any asset to buy… from coffee futures to micro cap stocks to Vodafone (Vod).
The rule of thumb is that If you’re trading in a safer, less volatile asset, the stop-loss percentage should decrease and the position size should increase. If on the other hand you are investing in a riskier, more volatile asset, the stop-loss percentage should typically increase and the position size should decrease.