One of the most frequently asked question in stock trading is 'how much money should I place in a trade?'.
The quick answer to this is that there should always be a carefully planned decision making process before you can determine the proper amount necessary for a trade.
Buying a stock just because you want to buy it or because it is 'cheap' will usually lead to BIG losses. This has been one of the main reasons why so many people who started trading in the market end up with chronic losses over time.
Remember that it is your hard earned money on the line when you begin investing or trading in the stock market. As such, you want to make all the necessary steps to ensure that you lessen the risk and increase the chance to grow your money over time.
In this post, we will provide a basic decision making process on how you can determine the right amount of money for a particular trade.
What is Position Sizing?
Position sizing refers to the amount of money in your portfolio that you are willing to allocate in a particular trade. The decision making process needed to determine this involves a thorough process predicated on risk management.
Basically, determining the right amount of money for a trade largely depends on the risk:reward ratio and the quality of the setup based on your trade strategy.
What does these all mean? Let's discuss each component in detail.
1. Risk: Reward Ratio:
Risk/reward ratio measures a trade’s potential loss versus its potential profit. The goal is to avoid trades that have a 50/50 chance of both loss and profit. Potential upside should always heavily outweigh the risk.
The risk meter below illustrates the amount of risk that a trader must acknowledge when evaluating any investment. You always want to lower the risk while maintaining a high degree of upside.
Here are two key examples:
Sample of a healthy risk:reward ratio:
The chart below shows a standard swing range setup. Upside range is above 10% while the potential downside risk is only -2 to -4%. The risk:reward ratio here is healthy and is the ideal basis for a swing trade with a low risk and a high reward ratio. Ideally, traders will not stop here and look for other technical signals and patterns that will further validate the exact entry, exit, and cutloss point to build the core structure of the trade plan.
Sample of an unhealthy risk:reward ratio:
The chart below illustrates a high risk ratio. Though the reward is up to 10%, the potential risk if the support level fails will also be more than -10%. As such, a trader will incur big losses if the trade fails. This is exactly the type of risk: reward that should be avoided at all costs.
Nothing emphasizes the importance of risk management more than the chart below. The bigger the loss, the harder it is to regain. This is why careful application of the risk:reward ratio is mandatory for all traders. BIG wins, small wins, and small losses. Those are the only outcome that should come out of your trade strategy. Never let a BIG loss hit you or it will completely wipe you out!
2. Quality of the Trade Setup:
The quality of a trade is determined by how well it aligns to your overall trade strategy. The more technical and fundamental parameters are checked in your criteria, the higher the quality of the trade is.
High Quality
Stocks that check ALL criteria of your trade strategy
Average Quality
Stocks that check 3 to 5 criteria of your trade strategy
Low Quality
Stocks that check only 1 to 2 criteria of your trade strategy
The quality of a trade can be broken down to Technical and Fundamental attributes that can be organized to create a criteria list. Essentially, the quality of the trade improves when it checks more items in the criteria list.
As a guide on quality trade setups, read our previous post HERE.
Example Criteria List for a Standard Swing Trade:
a. Technical Criteria
Weekly and daily timeframe are in an uptrend
Price is pulling back from a previous breakout and must bounce at EMA9
Volume decreasing on pullback
Role reversal bounce from a previous resistance level
Sharp bullish divergence on the 15 minute timeframe is the entry signal when price hits support on the daily timeframe
b. Fundamental Criteria:
Market capitalization must be 20 billion or more.
Must not be illiquid.
To novice traders, most of the criteria items on that list may sound too technical. This is because technical patterns and signals used in a trade strategy are very specific and vary from trader to trader. When you know what you are looking for then there is clarity. When there is clarity then the strategy can be executed with precision.
How Much Money SHOULD you Place in a Stock?
Now that you know the two major components used in Position Sizing, let us combine them together.
When you have identified the risk:reward ratio and the stocks that meet your technical and fundamental criteria, you can make a straightforward decision on the right amount of money that can be placed in the trade.
Looking at the guide below, it is pretty simple. The higher the risk, the lower the allocation should be. You only put a larger amount on a trade that has a low risk:high upside ratio, which meets 3 to 5 items of your stock selection criteria. After this, disciplined execution will handle the rest.
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