Stock trading involves more than simply identifying stocks that have the appropriate directional bias. You also must have a plan for preserving your capital and ensuring you will have enough of a buffer to survive the inevitable draw down periods. Before I can enter a trade, I must know exactly where my stop will be. The number of shares I purchase is determined based on this value.
Many traders will simply purchase an even dollar amount or an even number of shares in each trade. This method will cause traders to have a variable loss size. For instance one trade may result in a $50 loss while another trade results in a $500 loss. This variability in losses makes it harder to manage your overall portfolio risk. I manage my position sizing slightly different. Using a “max loss” dollar amount, I determine how many shares it takes to reach that loss if the stop is hit.
Position Sizing Example:
Current Stock Price: $20
Nearest Support Level: $18
Max Loss Willing to take: $100
Shares to buy: 50
This was calculated by the following formula: 100 / (20-18) = 50
Using this method of position sizing, stocks that allow for a tight stop loss will produce higher rates of return while stocks with wide stop losses produce sub par returns. You will notice in my daily stock analysis, that I have a tendency to discount signals that result in a wide stop loss for this reason. I rather preserve my capital until a better signal is generated.