The single most important thing you can do when buying a stock is manage the risk to your portfolio. Today I will walk you through the process of how, once I have identified a stock to purchase, to size that purchase and manage the risk.
For our example I will use yesterday's pick, LNET - Lodgenet Entertainment. I will need to know a few things before I start calculating the purchase specifics. Grab a stickie and note the following:
- The anticipated purchase price of the stock (17.90)
- the current ATR of the stock. (I use a 14 day - you should use whatever fits your trading time frame) (For LNET today this is .311)
- Your current total account balance ($100,000)
The idea with this process is that I want to size my purchase based upon the amount of risk in the trade. With this process, the dollar amount of my trades will vary widely, but the amount of risk in the trade will be approximately the same.
ATR, or Average True Range, helps us to measure the volatility of a stock over a given time range, in this case, the last 14 trading days. With a ATR(14) of .311, you could reasonably expect LNET to move .31 in any given day. Since we don't want to be stopped out of our trade my normal movement, we'll plan to put a stop in below our purchase price (for long trades). Putting that stop at 2 x ATR allows us room for movement, but protects us in the event of an unusually adverse move. If we were stopped out, we would lose 2 ATR, or 62 cents. This is the amount we are putting at risk in this trade. (I like to use stockcharts.com to get ATR)
I typically risk 1% of my portfolio on any given trade. This amount fluctuate based on the performance of my portfolio, but never exceeds 2%. At a current risk level of 1%, this means that I am willing to risk $1000 of a $100,000 account. (I always was a math stud.)
With $1000 to risk, and now knowing that we will risk .62 for every share that we trade, we can arrive at the # of share we want to buy by dividing:
$1000 / .62 = 1612.9032 shares
I find that I get cleaner execution in round lots, so I would round this down to 1600 shares. I would place the buy order for 1600 shares along with the accompanying stop order to sell at 17.28 .
Each of the trades is an equal "unit" of risk. This method allows you to balance risk across every trade, and further allows to me manage exposure to a given sector. I try to limit exposure to any one sector by balancing the # of units across sectors, and even trying to find inversely correlated sectors to trade when I am heavy in a sector.
Standardizing risk-per-trade lends itself to system development and measurement, and enables money management to be added to back-testing programs, providing more accurate outcomes for each tested scenario.
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