Size Does Matter

ppteam

A common mistake traders make is getting into positions with the wrong share size. This can cause a lot of money to be lost or at the very least impede on profits.

Before entering a trade, a successful trader determines his/her share size using three criteria; price, volatility, and volume.

Every trader has a different amount of capital of which to trade. That in itself can limit how many shares he/she can buy or sell. A common mistake is for people to focus solely on stocks that are very low in price. The cheaper the stock, the more shares you can buy or short, but that doesn’t mean you should be getting involved in these positions in a lot of size. Often people max-out their buying power into stocks that trade at cheap levels and hope for major moves. Instead they see daily movement of less than $0.05. Unless you are aware of a fundamental or technical reason why a low priced stock should jump in price, I advise you to stay away. Don’t be afraid of high priced stocks; you can often spot trends and indicators more clearly in them.

Volatility is crucial to determining size; the more volatile the name the less shares you should own. I trade with a seven figure account and therefore can afford to buy and short large quantities of any stocks. However, when trading stocks that are highly volatile like AAPL, GOOG, or MA, I cut my share size down. To trade these stocks I know that I must give them a lot of room to move around, thus placing my protective stop order far enough away as to not get hit out prematurely before the move I expect commences. If I trade stocks with less volatility like ORCL, MSFT, or INTC then I can buy more shares as they have less volatility and therefore I don’t need to place my protective stop as far away.

The amount of shares a stock trades, also called volume, is an often overlooked element when determining share size. Readers will often ask me my opinion about stocks and the first thing I notice is that many of the names have an average daily volume under 100,000 shares.

If you put a market order into a stock that trades with low volume it’s plausible you will be paying $0.50 higher than you wanted for your entry price. Fact of the matter is that in stocks with low volume there aren’t enough sellers in the stock for you to buy from at prices that are reasonable. When trading light volume stocks, small share size is recommended. I advise my students to trade stocks in the short term that trade more than 500,000 in average daily volume.

When deciding how many shares to buy or short of a stock instead of thinking about how much money you could make, think about how much money you are willing to risk if things go badly.

Here’s an example – you want to buy a $25 stock. You use these three criteria (price, volatility, and volume) to determine that you should risk $0.50. You aren’t willing to risk more than $200 in the trade. Therefore you can purchase 400 shares of the stock. If you buy the stock at $25 and things don’t work out the way you expected and your protective stop order is triggered at $24.50 you would lose $200 (400 shares x $0.50 = $200).

Determining share size is key to every trading plan. If you aren’t already, embrace this methodology and it will not only save you money but will help your trading be more profitable and consistent.

flash