When trading in the stock market, position sizing is where all the tools of money management come together. It`s perhaps the most important part of your stock market money management rules. Position sizing is simply deciding how much you are going to put into any one stock market trade. You can calculate your position size using the other tools of stock market money management, your maximum loss and your stop loss.
However, many stock market traders believe that they`re doing an adequate job of position sizing by simply having a stop loss in place. While this will tell them when to get out of a stock market position, and will, with a maximum loss, determine how much capital they`re risking, it doesn`t answer the question of how much or how many units they can buy.
If you have already calculated your maximum loss and your stop loss, you can take these values, and plug them into a formula that will calculate how many shares you can purchase without exceeding your maximum loss. Although it is simple, the formula I`m about to give you is extremely powerful. The number of shares for your position is equal to your maximum loss divided by your stop loss size.
You`re already familiar with what a maximum loss is; but may not be recognize the term stop loss size. A stop loss size is the difference between your entry price and your stop loss value. If you were to enter the stock market with a one-dollar trade and set your stop loss at 90 cents, the stop loss value would be the difference between your entry price and your stock price, ten cents. Once you`ve entered these values into the formula, you can calculate how many shares you should buy so that you never risk more than your maximum loss.
Let`s look at how the formula works in practice. If your trading float was $20,000, and you were risking 2%, your maximum loss would be $400. If your stock market entry price was one dollar, and your stop loss value was 90 cents, your stop size would be ten cents. Now, the number of shares is equal to your maximum loss divided by your stop size. In this example, you can purchase 4,000 shares. If this stock reaches your stop loss, and you have to exit the position, you know you`re not going to risk or lose more than 2% of your float, which is $400.
This formula ensures the safety of your trading float. A little finessing that some of my clients like to do is to class their brokerage fee as part of the maximum loss. You could do this by subtracting the stock market brokerage fee from your maximum loss. If the stock market brokerage fee was $40 for your return trip, subtract 40 dollars from your maximum loss. Instead of entering $400 into the formula, you`d now enter $360. Once this is computed out, you can determine how many shares you`d buy, and know that you had included brokerage as part of your maximum loss.
By setting your position size so that you follow the 2% rule, you`re using a strategy that will limit the size of your losses during losing streaks. When you experience a winning streak, your position sizes will grow in a similar manner. By changing the amount of capital you`re deciding to risk, you`ll change the characteristics of your risk to reward ratio. All of your stock market money management rules will work together to make your trading system as profitable as possible.