March 29 - Portfolio Control

Whenever someone hears of my trading the first question they ask is..... "what's a good stock for me to trade?"

A lot of people see trading as the buying and selling of stocks; pick the right stock and you make money. In fact there is much more involved... so much more!

Picking the right stock/option/commodity to trade is not even half the battle. Aside from the main buying and selling side of trading, there is another part..... not as sexy as the thrill of buying and selling and seeing the profit appear in your account, but this hidden side of trading makes sure that your account doesn't get out of control and that the money stays in your account.

This other hidden side is the portfolio control. It consists of many things, one of which is position sizing. This means if you have $100k in your account, you don't put $70k into a Google trade just because you think it will go your way. The risk on any trade should be in the range of 1-3% of your total account. This assures that if the market should go against you, and the trade ends up in a loss it does not put a big dent in your account (or ego) and you can go on again.

Based on this risk limit, you can size your positions. There are many different ways to calculate position sizing. I will discuss one here. The formula for the number of shares you want to buy is:

# of shares = risk $ / (swing price average/2)

, where,

# of shares - is rounded down to nearest 100 shares

risk $ - is your amount of cash at risk (for a 3% risk in a $100k account, this is $3,000)

swing price average - is the approximate swing in price you expect from the stock

The swing price average depends on what kind of trader you are and what kind of trade you're taking, if you plan to close out position within the day, the week, or possible hold for a long trade.

Let's say that you want to go long on AAPL, and let's also say that this is not a day trade and you've spotted a longer term-trade that you expect to work out in the range of a couple of weeks. To determine the average daily swing that you should think about, you want to calculate the 2-week or 14-day Average True Range of that stock. Stockcharts calculates and plots this for you.

The 14-day ATR is around $4, which indicates an average daily movement of $4/day. The ATR is not constant, it chances as the daily prices become more or less volatile. You can see that back in early February the range was as $6. During the volatile days of 2008/09 this range had gone up to $15/day. But it is a good measure of recent prices changes.

1

Based on this information, a good position size would be:

size = $3000 / ($4 * 2) = 375

since we don't want to buy in odd lots, we round this down to 300 shares. This ensures that your position can endure the ups and downs associated with normal daily volatility within this stock and you don't hit your risk limit prematurely. Be careful of news heavy days, for a short-term position the ATR may not be a good judge of what a price swing may look like on a news heavy day.... for example AAPL could move way more than $4 on a news heavy day like earning release day.

More on portfolio control to come....