How many traders have watched their trading account balance dwindle over the last couple of years as the US stock market has been humbled?
Managing the risk of each and everyone one of your trades allows you to remain in the stock market – no matter what the market does.
This trading lesson shows you exactly how to calculate the correct number of shares to trade based on the perceived risk.
How much can I lose?
The very first question you should ask yourself when considering a trade is “How much money can I lose?”
That one question will save you money!
If you are a trader, this is clearly the most important question you can ask yourself. Even as a long term investor, you still need to consider this question. Can you handle the value of your investment losing half it’s value, what about becoming worthless?
Here’s what most people do.
Most people will buy a stock with visions of scoring the triple digit gains, buying a stock and plan on selling when it more than doubles.
Here are some scenarios.
Buy the stock at the current market price. Watch the stock price as it either moves favorably in the intended direction or loses value. Either way, the key word here is watch.
If the stock price goes up, the trader congratulates him or herself on buying the stock. Maybe the stock gains at least 100%. And maybe the trader sells out after making the gains.
Or, more typically, the stock does go up, but nowhere close to doubling in price. The purchase is profitable and the trader sits on the trade waiting for the stock to continue up.
And finally, the account destroying actions occur – at some point the trade turns into a losing trade. What’s going through the traders mind now?
“I’ll wait until the price gets back to breakeven, then get out.”
“I know this stock is a winner, I’m not selling.”
“I think this is the best company in the world, I’ll buy more shares at the lower price.”
The stock price continues lower. Finally, the trader realizes the hopelessness of it all and sells out taking a huge loss.
You know what you are doing.
For you, it’s different. Since you are on your way to making and keeping money by trading stocks, your course of action is different than most people.
You don’t think!
You already know what you will do if the trade drops in value. You will exit the position with no hesitation. This doesn’t mean that it won’t hurt you to see your account drop in value. But, as a successful trader you know that this is part of trading – the losses are just part of the process of trading.
Your trading plan includes knowing at what price you will enter a stock and at what price you will exit a stock – especially if it is moving unfavorably for you.
Here’s the exact formula for the number of shares to trade.
One of the only things you can control once you are in a trade is at what price you will get out.
There are exceptions to this, of course. If a company comes out with bad news overnight, you can be almost certain that the stock price will be lower the next trading day – probably much lower. In that case, you initial exit point might be lower than originally planned resulting in a bigger loss than you would like.
For the most case, you can anticipate at what price you will exit if the trades moves unfavorably for you. With this in mind, here’s how you determine how many shares to trade.
The number of shares traded on any one trade is determined by your account size, the perceived risk, and the amount of your account you are willing to risk.
The account size is the easy part of the equation, simply the total value of your trading account including cash and stocks.
The perceived risk is determined by you before placing the trade.
The perceived risk is the difference between the price you enter at and the price you plan on exiting at if the stocks goes in the wrong direction.
If you plan on buying a stock while it is trading at $25 and will sell the position if the stock drops to $22, then your perceived risk on the trade is $3 per share.
The amount of your account you are willing to risk should never be more than 3%, even less is better. If you only risk a small amount of your account on any one trade, then in theory you can never go broke! Think about that for awhile!
# shares = (3% * account value) / (entry price – exit price)
If you have an account valued at $50,000 and you buy a stock at $25 and plan on exiting at $22, then the number of shares to trade is:
# shares = (3% * $50,000) / ($25 – $22)
# shares = 500 shares
If you only want to risk 2% of your account, then the number of shares looks like this:
# shares = (2% * $50,000)/($25 – $22)
#shares = 333 shares
For Microsoft Excel users, a spreadsheet to calculate the number of shares looks like this:
In this case, the entry price, exit price, %risk, and account value are typed into B2, C2, D2, and E2, respectively. The formula for calculating the # of shares is in A2 and looks like this:
Make the most by losing the least.
Even if your system for picking stocks to trade is marginal, your returns will be better than someone who has the best stock picking system and the worst money management skills.
The simple formula shown here keeps your account from ever risking more than a fixed percentage on any one trade.
Get your hands on a trading method that finds and trades the biggest stock market winners . without risking your entire trading account.
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*** Article by Dave Wooding of the Wooding Trading Company. Dave’s site includes useful stock market trading information. Visit https://www.woodingtrading.com for more FREE information about how the stock market works, trading tutorials and stock market education. If you would like to receive information on a regular basis, simply sign up at https://www.woodingtrading.com/stock-market-newsletter. html
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