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4 Steps to Lower Stock Market Risk

Monday, August 10, 2009

4 Steps to Lower Stock Market Risk

Position Sizing to Limit Investment Risk

1) Determine the maximum amount of your capital you are willing to lose on a single position. You may consider this in dollar terms or as a percentage of your entire investment portfolio. For example, if your account size is $10,000 you may consider your maximum loss to be 1% of your entire portfolio or $100.

2) Determine your stop loss on the investment. Many people employ a 3 times the weekly volatility stop. To do this you need to calculate the range a stock moves during a week, multiply that by 3 and then subtract that number from your entry point if you purchased a stock. Set that as an automatic stop trigger so that your position sells immediately if the stock drops below that point. If you are a longer term trader 10 times the volatility is often more beneficial. For example on Yellow Pages Income Fund YLO.UN 3 times the weekly volatility (maximum price to minimum for last 5 trading days $5 to $5.21) represents a stop loss of $0.21 * 3 = $0.63, which translates into a stop for a Tuesday Morning Entrance of ($5.01 – 0.21 = $4.80. This helps eliminate the noise of the market from your investment.

3) Take the maximum loss in dollar terms determined in step 1 and divided that number by the percentage loss the stop loss would represent ($0.21/$5.01 = 4.19%). For example, on Yellow Pages Income Fund YLO.UN you would calculate $100/4.19% = $2,386. This represents the dollar amount that your could hold of the stock while sustaining the maximum loss you are willing to tolerate in your portfolio.

4) The amount of shares you should buy is simply the dollar amount determined in #3 divided by the current share price ($2,386/$5.01 = 476 shares). It normally only makes sense to buy shares in lots of 100 so you need to decide whether you want to round up or down since it will affect the overall risk slightly here.

Obviously, the lower the volatility in a stock the larger the position size your could have. Also, the larger your account size the larger the positions.

Everyone is different and can sustain different levels of losses and still sleep at night. Investing should be fun so if you find you lose sleep at night thinking about your profits or losses you probably need to lower your risk.

The next step is then to determine when do you take your profit; this is the hardest part of investing.

1 comment:

Chris the Capitalist said...

Good article dude! One more thing to add; most professional traders recommend not losing more than 2% of your equity in any single play. I would recommend starting at 2%, and decreasing that percentage as losses mount if you're on a losing streak.

Furthermore, be weary of the fact that 6 plays in energy equities is basically 1 large play, as all 6 are highly correlated. Just something to be aware of when calculating your risk.