How large or how small should your position be in any given trade? Before I get into the answer to that, there is one prerequisite that supersedes everything, the liquidity of what you're looking to trade. You need to keep your position size to as small of a percentage as the average daily money volume. You can estimate the average money volume by taking the price and multiplying it by the average amount of shares traded daily. If a stock that is trading at $1 averages in between 100,000 and 300,000 shares, the average money volume is probably in the ballpark of $200,000. How much of the average money volume do you want to be? The less the better, but there is no official threshold to stay under. I'd say staying under 2% is pretty safe, but if you know what you're doing you can push that somewhat. There have been plenty of trades where I've gone well over 2%, but in those cases if I didn't get buying momentum to sell into, I paid the price.
As long as you have the liquidity issue covered, here is how I determine my position size. To start with, I need to know a few things to figure out what my position size should be. Those are; How much I'm willing to lose on this trade, where my entry is, and where my stop loss is at. For example, say I'm watching a stock that is an uptrend, but it's currently falling back to support at $1. Since the longer term trend is up, I'm looking to buy into the support at $1, but if that support fails to hold, I'm going to bail. The most I want to risk losing on the trade is $200. That doesn't mean my position size will be $200 worth of shares, that means that should my stop loss get triggered I only want to lose $200. So my entry is at $1, and my stop loss will be enough below that to allow for normal market fluctuations, we'll say at $.95. So now I know all the factors to determine my position size. My maximum risk is going to be $200, the entry is at $1, and the stop loss is at $.95. Based on that, my position size would be 4000 shares. 4000 shares multiplied by $1 is $4000, and 5% of that (which is what my stop loss is set at) is $200. An easy way to figure this out is by dividing your maximum risk amount by the percentage of the stop loss. In this case, it would be $200/ 5%, which would give the $4,000 figure. You then just need to factor how many shares you can buy with that amount.
If you always risked the same amount on every trade and kept an arbitrary percentage for your stop losses, your position size would always be the same (in dollars). My problem with this is that an arbitrary percentage doesn't make sense to me since all stocks and charts are different. The stock and the chart should dictate your stop loss. A 5% stop may work great on one stock, but on another much more volatile one it may get triggered way too easily. If you feel that on a certain trade you need a 10% - 20% stop loss because of either the volatility, where the closest, most relevant support/resistance is at, or both, then use that wider stop, but adjust your position size accordingly. That way, you're still allowing the proper amount of buffer room for price fluctuations, but you're still risking the same amount if your stop gets hit.
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