Position Sizing

Position sizing is one of the key factors in succeeding in stock trading yet lots of people overlook position sizing or do it the wrong way. 

Cases

1. Person A simply takes the full amount of his trading capital and bet on 1 stock. Sit back and hope the stock will go up.
2. Person B thinks it is better to split the risk so he decides to split into 5-10 stocks. Sit back and hope at least some of them will go up.
3. Person C understands that stop loss and risk management are essential for stock trading. So, he comes up with a trading plan apart from splitting the capital into 5-10 stocks. As long as the capital invested in each stock drop more than 5%, he will sell the specific stock to limit the loss. Else he just let the rest of the stocks to run. He is a firm believer of "cut your losses short, and let your profit run". 

Problems

So what exactly is the problem for person A, B & C?

1. Can you imagine what will happen to Person A if the stock gaps down 10-20% after earning announcement? Or the only stock he holds is suspended by Bursa due to "some reasons to be further investigated?" Or the stock just does not perform as he expected.
2. For Person B, he spreads his capital into 5-10 stocks so black swan event will not hurt him a lot and the risk of all his stocks do not perform is lower. However, he does not come up with a trading plan. What will happen if some of his stocks drop by 5%? 10? 20? Will he still hold and hope it will go up eventually? A trader's priority is to take care of his downside and let the upside to take care itself.
3. Although Person C seems to have a trading plan in place and limit each stock's loss to only 5%, this is not the right way to determine the stop loss point. Of course, such a plan is definitely better than Person A & B, who do not have any plan at all. However, having a wrong trading plan will cost you unnecessary amount of money due to price fluctuation. Stop loss should be determined right after the entry price such that the stop loss point will violate the bullish structure. Stop loss topic will be further discussed in the future posts. Refer to the HIBISCS example below.

Process of Position Sizing

Let's assume our initial capital to start stocks trading is RM100,000 and we are keen to trade 5 (or 10 to further diversify) stocks, which you have been monitoring for a while. 

In addition, we will ignore scaling in/scaling out during the trading process.

Let's take these 5 stocks JHM, PRESTAR, YONGTAI, PESONA & HIBISCS as an example for position sizing.  We will allocate RM20,000 for each of the stock. 

Entry Price

Assuming we enter these 5 stocks based on today's closing price.

1. JHM - 1.70
2. PRESTAR - 0.97
3. YONGTAI - 1.24
4. PESONA - 0.61
5. HIBISCS - 0.445

Stop Loss

Before we buy the counters, we need to first work out the stop loss point for each stock so that we know how many lots can we buy. This is a critical step and lots of people overlook this and end up miserably in stocks trading. 

There are many ways to determine the stop loss for a stock. And this will be a great topic to discuss in my future post.

For now, I will just refer back to my previous analysis and set the stop loss based on the pattern.

For JHM, 1.45 is the stop loss and it is below the second rounding bottom, as marked in brown colour. 

For PRESTAR, the stop loss will be 0.76, below the red circle as illustrated in the PRESTAR analysis.

For YONGTAI, the stop loss will be 1.16, just below the uptrend line and the blue circle as shown in the YONGTAI post.

For PESONA, the stop loss will be 0.56, below the previous swing low.

For HIBISCS, the stop loss will be 0.36, below the resistance turned support trendline.

Lot Size

After determining the stop loss, it is time to calculate the maximum lot size we can buy based on our previous allocated fund RM20,000. Assuming we only risk 5% on each stock, i.e. not losing more than 5% of the allocated amount (RM20,000), which is RM1000.

Correct Way

JHM: 1000/(1.7-1.45) = 4000 shares, spent RM6,800

PRESTAR: 1000/(0.97-0.76) = 4761 ==> 4700 shares, spent RM4,559

YONGTAI: 1000/(1.24-1.16) = 12,500 shares, spent RM15,500

PESONA: 1000/(0.61-0.56) = 20,000 shares, spent RM12,200

HIBISCS: 1000/(0.445-0.36) = 11764 ==> 11,700 shares, spent RM5,206

The lot size is determined based on the stop loss price. So, in case the price turn against us and hit the stop-loss, the maximum amount we will lose is the risk we are willing to take, in this case, 5%, or RM1000 for each stock. If all 5 stocks hit the stop-loss, the maximum loss is RM5,000, i.e. 5% of the trading capital

What about the rest of the money? You can use it if you spot other trading opportunities or scale in the same positions when they go up.

Are you still confused? Let's look at another scenario below:

Fully invest the RM20,000 to each of the stock with the same stop-loss

JHM: 20000/1.7 = 11764 ==> 11,700 shares, potential loss = 11,700*(1.7-1.45) = RM2925

PRESTAR: 20000/0.97 = 20618 ==> 20,600 shares, potential loss = 20,600*(0.97-0.76) = RM4326

YONGTAI: 20000/1.24 = 16129 ==> 16,100 shares, potential loss = 16,100*(1.24-1.16) = RM1288

PESONA: 20000/0.61 = 32786 ==> 32,700 shares, potential loss = 32,700*(0.61-0.56) = RM1635

HIBISCS: 20000/0.445 = 44943 ==> 44,900 shares, potential loss = 44,900*(0.445-0.36) = RM3816

If all 5 stocks hit stop-loss, the maximum loss is RM13990 or 14% of the trading capital.

Some of you might be wondering what about using Person C's approach? i.e. to spend all RM20,000 on each stock but limit the stop loss to 5% by working backwards to determine the stop loss. 

For example, HIBISCS: 20000/0.445 = 44,900 shares, limit potential loss to 5% of RM20,000, i.e. RM1,000, the stop loss of HIBISCS will be 0.445*0.95 = 0.42275 ==> 0.425

Yes, you can set this super tight stop loss but do you think the price of HIBISCS can easily retrace 0.02 before resuming the bullish momentum and trend higher? Your tight stop loss will be easily hit. 

Ask yourself these questions before you enter a position:

Am I comfortable to lose 5% of my invested capital? Is this within my threshold? Can I sleep well at night if one stock hits the stop loss and I lose RM1000? What about all 5 stocks hit the stop loss and I lose RM5000?

If the answer is NO. You can always adjust the risk you are willing to take for each stock until you are good with that. The smaller risk you are willing to take, the smaller lot size you can buy for each stock. Else you can adjust your risk higher.

I recommend not to risk more than 20% (for the super aggressive trader) of your trading capital, i.e. should all stocks hit the stop loss, you will at most lose 20% of your trading capital.

Think about it this way, if you lose 20% of your trading capital, you will need to earn 25% to recover your lost capital. The more you lose, the harder you will recoup the losses.

You will notice that the lot size is a dependant on the amount you are willing to risk, your entry price and your stop loss. If you would like to buy more without enduring higher risk, you can always enter at a better price, i.e. lower price, or to have a tighter stop loss.

However, bear in mind that you will need to have some buffer to let the price to fluctuate. If you have a super tight stop loss, you will be easily stopped out before the price turns in your favour. The stop loss should be set at a point where it violates the bullish structure, which I will elaborate more in my future posts.

Topics That You Do Not Want To Miss

How to determine the "bullishness" of the patterns- https://www.facebook.com/BursaSGXcandlestick/videos/378260995905662/

The Trade Management Technique You Need To Know - http://klse.i3investor.com/blogs/candlestick/114496.jsp

Best Way To Learn To Trade Without A Mentor - http://klse.i3investor.com/blogs/candlestick/113821.jsp

Entry Illustration - http://klse.i3investor.com/blogs/candlestick/113605.jsp

Stop Loss & Safe Trading - http://klse.i3investor.com/blogs/candlestick/113510.jsp

Come Up With Trading Ideas & Turn Them Into Investing Ideas - http://klse.i3investor.com/blogs/candlestick/114110.jsp

Cheers,

Ming Jong

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