Friday, September 27, 2013

How Many Should I buy? (by Osikani)

Following is an old post written by Osikani back in May 2010 when a lot of people did not want to accept that market has nothing to do with fundamentals and had really difficult time trading and Osikani was kind enough to share his enormous (no pun intended) experience on how to survive as independent trader.
Read up

Talking about position sizing.
Lately I have been feeling homicidal, as this market has kept faking me out. The only reason I am still solvent, after foolishly fighting the Fed for so long is my now ruthless and speedy exit from my numerous losing positions, and my staying in on the few days that give me traction. It takes a good whipping from Ms. Market to begin to appreciate how to stop being patient with losers, and being panicked into quick exits with small profits. Some pundits will tell you that in the market, there are fear and greed. Do not believe it; there is only one emotion in the market: FEAR. We exit too soon because we are afraid to give back our crumbs after we have been whipped so hard for so long because we were afraid to take our loss, just in case the hopium was real.
All of which leads to questions of risk. It may be paradoxical to some, but ALL positions in the market are function ONLY of risk. If we do not control our risk, we lose our shirts, and a few things besides. That is why I have taken a request out of the blog, asking about how to calculate position size, and will use it for a discussion that ranges a bit deeper than that.
We shall discuss:
  • How our risk determines our position size.
  • The likelihood of our being taken out by a stop loss.
  • A more efficient means of staying in our position without using a stop loss, allowing greater ability to hold the fort, so to speak.
  • A more efficient use of capital to handle the same risk.
To do this we shall start by building a position in the fictional XYZ Corporation. Once again, simply because it is generally easier to understand the concept of buying something, and then making money as it increases in value, or losing money as it drops in value, we shall look at a long position.
1. What are you willing to lose per share?
This is where most traders start. Whereas it is not the best place to start, it is still a valid one. So let us say that XYZ is currently at $50 (nice round numbers, to make thing easy), and you have determined using your latest technical analysis, or guru, that you will use a Stop Loss of $47.50 for whatever reason.
That implies that you are willing to lose &2.50 (Price - "Stop Loss") per share.
2. How much of your equity are you willing to lose if you get taken out immediately?
This is really the first question to ask. Let us assume that you have an account with $40,000 free equity (essentially the cash in the account).
The first thing is to decide what percentage you are willing to lose. I cannot think of any other method that makes sense, but I am sure there are some. A fixed amount is a bad idea because it means that if your account starts to lose, then you are risking more on each trade, and as your account increases, you are risking a whole lot less. While it makes sense to risk less on a larger account, that is probably only really true when we get to 7 figure accounts. Regardless, we shall risk 2% of our free equity.
If we allow only a 2% loss per position, then the maximum that we think we are willing to lose is 0.02 x $40k = $800. (2% = 2/100 = 0.02).
3. What then should be our position size?
This may hurt some feelings, but I have found that the American education system like to reduce mathematics to a long farrago of memorizing formulas for specific situations, instead of stressing that math is just a convenient way to use number to understand reality. As I insist that it is easier to remember if one understands, let us try to understand what we are doing here.
Essentially, what we are asking is this: If I am willing to lose $800 in total, while losing $2.50 per share, how many shares should I buy? In that case, it becomes obvious that you are looking for the number of shares, such that if you lost $2.50 on each, it will amount to $800. That translates to:
"Total Loss" = "Number of Shares" x "Loss per share"
800 = "Number of shares" x 2.50
Please try to understand what I have explained instead of memorizing that formula, but the choice is yours.
This is not a course in elementary math, and I do not want to be condescending, but let us see how we can solve the equation. We are trying to isolate the "Number of Shares" to one side of the equation. There are two ways to think of how to do it, one convenient, the other mathematically rigorous.
First the convenient, which is how my brother initially taught me when I was having great difficulty.
Look at each element in the equation, and if there is any operand ( +, -, x, / ) in front of it, assume that the operand belongs to the term. If there is nothing, then assume a "+", but ONLY if you are going to move that term across the equals sign. So the terms then are 800 = "Number of Shares" (x 2.50).
Move the terms that you need to move to isolate your quantity, across the equal sign to the other side. WHENEVER a term moves across the equal sign, it will change its operand to the opposite; so a multiplication becomes a division; an addition becomes a subtraction and vice versa.
We then get: 800 (/2.5) = "Number of Shares", moving (x2.5) across the equal sign to become (/2.5) and as the two sides are always equal, we can simply switch them and have: Number of Shares = 800/2.5 = 320
Now the rigorous method. We want to isolate "Number of Shares", and anything multiplied by 1 is axiomatically itself, so we are going to reduce 2.5 to 1. Therefore, we divide both sides by 2.5. (To maintain the equality, you must do to the other side whatever you do to one side). We are then left with:
800/2.5 = Number of Shares x (2.5/2.5) = Number of Shares x 1
Number of Shares= 320.
4. How many shares should we really buy?
300, a round lot, making our risk now 2.5 x 300 = $750. If you insist on a total risk of $800, then the question now becomes: how large should be my stop loss so that on 300 shares, I can lose a maximum of 800.
This translates to:
"Total Loss" = "Number of Shares" x "Stop Less"
800 = "Stop Loss" x 300
800/300 = "Stop Loss"
"Stop Loss" = $2.66
5. Why 300 instead of 320 shares?
To the market makers, odd lots are the mark of an amateur, ripe for the plucking. Markets are driven to clusters of odd lots, especially when there are no real institutional players putting large orders on the tape. It is a simple matter of the market makers taking advantage of fear. A large cluster of odd lots just means a lot of fearful folks who can easily be panicked out, and help to drive the market into a quick fade and pop. Basically, they place buy orders just under the cluster and then start selling. As the selling intensifies, the odd lots (stops) are triggered as a quick series of trades, pushing down even harder. The market looks like it is tanking, then hits the waiting buy orders, and pops right back up. That is what is called a stop sweep. Remember, the playing field is NOT level; your counter-party, the market maker's book shows where all the orders are sitting.
As we do not want this to be too long, or it might not bet read, this concludes our brief exploration of position sizing. Our next write-up will continue with the other issues.
Hold your horses, and do not become one of these.
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