If you’re a new investor, chances are, you’re making this simple mistake…
“It’s crazy… She got it totally wrong, and she still won $250.”
My friend Adam was complaining about a trading contest he recently entered… and lost.
Adam did well, actually. He got second place. He was in gold stocks and cheap tech stocks. But he lost to someone who “bought” 100 shares of Netflix.
In fact, this contestant simply bought 100 shares of just about all of her positions. With Netflix at $400 a share, that one position took up $40,000… the bulk of her “portfolio.”
You’ve got to realize, these trading contests often don’t ask folks to put up real money. So the best strategy is to take on a lot of risk. If it works out, you win. If it doesn’t, no problem. Netflix did well, so she won. If Netflix hadn’t done well, though, her portfolio would have been destroyed.
When you’re working with real money, that’s not a great strategy.
It’s likely Adam’s opponent never realized how lopsided her portfolio was. A lot of folks, when they open a trade, simply select a nice “round” number of shares to buy.
You might get lucky and win the occasional trading contest that way. But when it comes to real money – your money – forget the round numbers. You’ll find yourself taking way to much risk in a company with a high share price.
Today, I’ll explain what to do instead… and I’ll show you three simple steps that you can use every time you trade to calculate how many shares to buy.
Fair warning: There’s some math involved. But if you have a calculator on your smartphone or laptop, it’ll be a cinch. Let’s get started…
1. The first step should be defining your exit strategy… like using a stop loss. A stop loss is the price at which you’ll exit the trade. It defines the size of your risk in the trade.
There are different types of stop losses… You might use a “hard” stop, which is simply a particular percentage below the current price. Or you might use a trailing stop, which moves higher as the share price moves higher.
2. Once you decide what type of stop loss to use, the next step is to decide the size of the risk to your portfolio.
This amount should be small enough that it will be easy to recover from. And it should be small enough that if you do lose it, it won’t keep you up at night. We recommend you keep this number at or under 1%.
3. Once you know your stop loss and the capital you’re willing to put at risk, you’re ready to calculate your position size…
This is where the math comes in.
First divide the percentage of your portfolio at risk by your stop-loss percentage. This will give you your position size as a percentage of your portfolio.
% Capital at risk / % Stop loss = % Position size
From here, you can get your dollar position size. Simply multiply your total portfolio size by your percentage stop.
% Position size * $ Portfolio size = $ Position size.
And finally, you get the number of shares to buy by dividing your dollar position size by the share price.
$ Position size / $ Share price = Number of shares to buy.
I think it’ll make more sense with a quick example…
Let’s say we want to buy shares of Acme Corp, which is trading at $20 a share. We’re going to use a 15% trailing stop. Our portfolio is $100,000. And we want to risk only 1% of that.
So our position size as a percentage of our portfolio is: 1% / 15% = 0.067, which is 6.7%.
And our dollar position size is: 6.7% * $100,000 = $6,700.
Therefor the number of shares we should buy is: $6,700 / $20 = 335.
That’s it. It takes a little more work than typing in “100.” But it’s worth it. You don’t want to put too much of your portfolio into one stock just because it has a high share price. It won’t always work out like Netflix did for the contest winner.
Adam is still bitter that he missed out on the top spot. But I bet when it comes to real money, he’ll win.
Amber Lee Mason
Crux note: Smart position sizing can instantly turn you into a low-risk, high-reward trader. Amber has created a video in which she explains this vital concept in more detail. We can’t say it any clearer: if you want to become a successful investor, you must learn to manage risk. You must avoid a catastrophic loss at all costs. Fortunately, it’s easier than you think… as Amber explains in this short video.
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