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Long Term Investor - How much of a stock should you buy?

Friday, August 21, 2009

Long Term Investor - How much of a stock should you buy? There are many different strategies that will alter the amount of a single stock that you should buy. This article will focus on the Long Term Investor and provide an example using Potash Corp./Saskatchewan Inc. (Public, TSE:POT).

The method that I am about to explain comes from Van K. Tharp’s ‘Trade Your Way To Financial Freedom.”

The CPR method (best method for long term traders)

The CPR stands for Cash / Position / Risk. The simple formula is this P = C/R.

P: Position, this will be the amount of shares to buy

C: Cash, this will be the total $ amount of your portfolio you are willing to risk on one trade. (Usually between 1-3% of your total portfolio)

R: Risk, the total $ amount of the stock you are willing to risk. For example, the stock is currently $100 and you set a stop loss of $4 then your R = $4.

To come up with the amount of shares to buy solve the formula.

Here is a real example using Potash Corp (TSE: POT)

Assumptions: My portfolio size is $70,000. As a long term trader I want to set my stop loss at a point that I will not likely get forced out in the near term so I set it at 3 times the weekly volatility (3x the difference between the Maximum and minimum price of the week).

Today the ask on POT is $104.38. If I look at the chart in Google Finance I can see that the max this week was $106.72 and the min was $100.54 which is a volatility of $6.18. To set my R I want to use 3 times the volatility: 3x $6.18 = $18.54.

Since this is a personal investment I am will to risk more that if I were managing the account so I will risk 3% of my entire portfolio: 3% x $70,000 = $2,100.

Set up the formula:

P = C/R = $2,100 / $18.54 = 113.27 shares.

Because most stocks trade in lots of 100 shares I will round down and buy 100 shares. By doing this calculation I am not over exposing the risk of my portfolio to a single trade. I will be investing $10,438 in this position and the most I am willing to lose is $2,100 or 3% of my entire portfolio.

Next step: If I get into a profitable position of greater than $2,100 than I will set a trailing stop to lock in some profits.

Obviously this is an expensive stock so if your portfolio is smaller than $40,000 it probably doesn’t make sense to own this stock since your risk exposure will be too large. The CPR method works for any stock though so test it out with anything from penny stocks to expensive stocks.

This article can be seen in the August 29th, 2009 edition of the Weekly Dividend Roundup
This article can also be seen in the September 3, 2009 edition of Carnival of Pecuniary Delights#22

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