By percent of capital

Setting your position size based on a percent of capital is the simplest way to allocate capital to new positions. For example, if you have an account worth $50,000 and select a 3 percent level of capital to invest in each security, you allocate $1,500 to each trade.

Many position traders (individuals with time horizons measured in months) invest an equal percentage of capital to each of their investments. As their capital base grows, they can invest more in each position. Conversely, as their capital base shrinks, they invest less in each position.

Ultimately, invest in ways you feel most comfortable with. However, I strongly advise against varying the percent of capital invested in new securities instead of using a constant percent of capital approach, because setting different percentages can result in random performance. Having a higher conviction in one trade (and thus allocating a higher percentage to it) may interfere with the success of your strategy if you’re a poor predictor of your own success. Trading doesn’t have to be complicated to be fun and profitable. Adding complexity where none is needed can lead to sub-par returns. If you want to vary your position size based on the attractiveness of the risk/reward present in the trading opportunity, skip to the next section.

You won’t find a hard and fast rule when it comes to selecting a specific percentage level to use in setting position size. Choose a percentage level that’s too small (such as 0.5 percent), and hitting a home run won’t do much to boost your bottom line. But select a level that’s too large (such as 10 percent), and you could lose your shirt if the stock gaps down hard. Your stop-loss levels can only limit risk so much, and a security that gaps down will result in a loss larger than the 0.25 percent to 2 percent limit described earlier.

Use the following rules to help you set your percent of capital position sizing level if you decide to use this method (as opposed to the risk level approach described in the next section).

• Set a small percent of capital level (2 percent to 4 percent) if you trade securities that exhibit
  • Illiquidity (remember, what’s liquid to you may not be liquid to a $1 billion investment fund; in other words, size matters)
  • Low share prices ($10 or less is low)
  • High betas (anything above 2.0)
  • Small capitalization size (below $300 million)
• Set a large percent of capital level (4 percent to 8 percent) if you trade securities that exhibit
  • Liquidity
  • High share prices
  • Low betas
  • Mid and large capitalization sizes

After setting the percent of capital you want to allocate to your trades, you have to set your stop-loss level. This part is easy given that you’ve already calculated your threshold of tolerable loss (refer to the earlier section “Figuring out how much you’re willing to lose”). Set your stop-loss level at the price that would cause the loss on your position to equal 0.75 percent of your total capital.

Here’s an example of this process at work: Assuming an account value of $50,000 and a loss threshold level of 0.75 percent, the maximum loss you can tolerate on any one position is $375. You determine the time is right to buy shares in Dummies Corporation at $40 per share. You also decide to use a 6 percent of capital allocation approach to your swing trading. Where do you place your stop loss?

Your stop loss should be set at a price that yields a loss of $375. Investing 6 percent of your assets in Dummies Corporation means you’ll buy 75 shares:

6 percent × $50,000 = $3,000 ÷ $40 per share = 75 shares

To arrive at your stop-loss level, divide your loss threshold by the number of shares you buy; then subtract the result from your purchase price to get your stop-loss level:

• $375 ÷ 75 shares = $5
• $40 – $5 = $35 stop-loss level

By risk level

Setting your position size using a percent of capital method may seem arbitrary. After all, isn’t that saying that you have no idea which trade will be profitable and which one won’t be?

Technically, the answer to your astute question is yes; in effect, you’re saying that you have no idea which trade will be profitable. But then again, you wouldn’t be trading in the first place if you knew the trade wouldn’t be profitable.

A smarter method of setting your position size is varying it according to your desired exit level. In the example that I set up in the previous section, you compute an exit level strictly based on the price that would produce a loss of 0.75 percent of your capital. Alternatively, you can determine a key level at which you want to exit and then determine a position size based on that level. This is how most professionals swing trade. An arbitrary price may have no meaning ($35 in the previous example), whereas a specific price level may signal the end or beginning of a trend. I use a chart to illustrate how a specific level can help you determine a position size.

Figure 10-1 shows a chart of Alphabet Inc., commonly referred to as Google. Google’s shares have been consolidating and look ready to break out. Eager to make a quick buck, you decide to purchase shares.

Before you calculate how large a position to take, assess the chart. This daily chart shows Google’s stock price from early April through mid-September. Google’s stock rose strongly from mid-May through late July — up 22 percent in two months. However, a poor earnings report sent Google’s stock sharply down (and serves as a reminder that trading around earnings reports can be hazardous).

Pretend today is September 18, and you’ve decided Google is worth a swing trade. How much of your capital should you invest?

Setting your position size based on a risk level requires you to determine a price that, if reached, indicates that the trade has gone sour. Obviously, if shares fall to $460, you have a hint that something isn’t right. But that’s far too late — you need a more immediate warning sign.

Try using a previous swing low as a line in the sand for your stop-loss level. In this example, assume that the recent swing low highlighted in the chart is the level that, if reached, indicates that you’re wrong about the trade. That level is $505.

Google’s stock is trading at $545, and you’re willing to risk 0.75 percent of your capital on each trade. (Remember: 0.75 percent represents the loss you’re willing to tolerate from a position, not the maximum amount you’re willing to allocate to a single position.) To calculate how many shares of Google to buy, use this formula and plug in your numbers:

• Amount of capital at risk ÷ (Entry price – Stop-loss level)
• $375 (or 0.75% of $50,000) ÷ ($545 – $505) = 9.375 shares, or 9 shares

Thus, setting your position size based on your risk level means purchasing 9 shares of Google. (Round down when you have a fraction. Rounding up may mean adding more risk, whereas rounding down always keeps you below your specified loss threshold.)

This example brings to light one weakness of this approach: The closer the exit price is to your entry price, the larger the implied position. In fact, if your exit price is $1 or less than your entry price, the preceding formula may tell you to invest more than your total capital in one stock, which makes no sense!

The solution to this weakness is to put a ceiling on the amount you invest in any security. Colin Nicholson, a prolific swing trader from Australia, places a 6 percent ceiling on his trades. In the example, if you purchase 9 shares of Google at $545, you’re investing 9.81 percent of your $50,000 capital in one stock.

Although technically only 0.75 percent of your capital is at risk (if you place your stop loss), there’s always a chance that the stock will gap down and cause your loss to be much greater than your stop-loss order. Stop-loss orders don’t guarantee an exit at the price specified because there’s always the chance a security may gap lower.

By number of securities

The most elementary way of diversifying your portfolio is simply to spread your assets across several securities. The more, the better — the thinking goes. But how many securities constitute a diversified portfolio?

The benefits of diversification can be realized with 10 to 20 securities, but I should warn you: This number assumes the companies are in different industries and countries. Investing in 10 semiconductor manufacturers doesn’t expose a portfolio to businesses outside of a small niche of the market.

Your trading plan should indicate a target number of positions you trade. The more positions you have, the less time you’ll have to devote to each single one and the more likely your returns will mirror the market. So keep your number below 20.

Following the position sizing guidelines outlined earlier in this chapter (see “Setting your position size”) largely takes care of this first point of diversification by number because the risk guidelines ensure that you have several positions. But if you’re going to brave the market without these guidelines, try to construct a portfolio of at least ten different positions and securities in different industries (see the following section for tips).

By industry exposure

According to William J. O’Neil, founder of Investor’s Business Daily, an industry group roughly determines 30 to 40 percent of a security’s return. So being exposed to only one or two industry groups is extremely risky because the returns of your securities will be very similar. Think about it in terms of the auto example from earlier in this chapter: Are the factors affecting General Motors and Ford all that different? Or United Airlines and Delta? Exxon Mobil and Chevron?

Figure 10-3 is an outline of the major industry sectors (as defined by the Global Industry Classification Standard, or GICS). Fortunately, the software services you use should break down the industry or economic sector that your securities belong to.

There’s nothing wrong with concentrating in a few sectors — say four or five. But beware of investing in only one or two sectors because you won’t benefit from the diversification benefits inherent in investing in different parts of the economy.

Be sure to set a minimum number of industry groups that you trade in. I recommend identifying at least three different sectors and trading a minimum of five different industry groups, smaller classification groupings than sectors. For example, healthcare equipment, healthcare providers, and healthcare technology are all industry groups in the healthcare sector so investing across these three industries would not diversify your portfolio outside of the healthcare sector.

By asset class and country

Another way to diversify your portfolio is to invest in different asset classes and countries. The asset classes you trade decrease your overall portfolio risk, so if you’re using this approach, you should shoot to trade two to three different asset classes. Different countries exhibit different risk characteristics; I try to trade equities in at least two to three different countries.

Three vehicles for achieving diversification by asset class and countries are exchange-traded funds (ETFs), American Depository Receipts (ADRs), and Real Estate Investment Trusts (REITs):

Predetermined profit target

A predetermined profit target is the easiest method of taking profits off the table. When you enter your trade, you set a specific gain (usually expressed in percentage terms) that you seek and then take your money off the table after that gain has been achieved.

Swing traders shouldn’t set unreasonable profit targets; your profit target is a function of your time horizon. Because swing traders’ horizons can vary from a few days to a few weeks, your profit target may range from the low single digits to the low double digits. If you’re active in the markets and trade often, then your profit target should be modest — closer to 5 percent. However, if you prefer to hold your swing trades for a few weeks, then a 15 percent or 20 percent profit target is attainable.

Some professional swing traders exit in stages. For example, they may sell 50 percent of their position after a security has risen 10 percent in price. Then they may ride the rest of the position until there’s a technical breakdown or change in fundamentals. The advantage of exiting in stages is that you lock in profits early. A security that rises 10 percent and then falls back to your entry price results in a 0 percent return if you failed to take profits on its way up.

Exiting in stages may improve your returns, but it also requires more work. There’s more record-keeping, for example, if you exit in stages versus exiting in one go. You also generate more commissions (unless the commission is based on a fixed percentage or cents per share), more work keeping track of open positions where you’ve taken partial profits, and so on. Make sure that your strategy fits your work ethic and time commitment to the market.

Predetermined price target

A predetermined price target is an alternative way to take money off the table. In this case, you set a specific target based on the chart or the fundamentals of the company.

In the case of technical alert criteria, you may set your profit target equal to a prior swing high or swing low. Securities tend to find resistance and support at price levels achieved in the past, so you may set your target on the basis that the security will reach that prior peak. (I cover how to determine technical alert criteria in Chapters 4 and 5.)

In the case of fundamental criteria, you may set your profit target equal to a price multiple of the security — a price multiple based on earnings, sales, and so on (see Chapter 9 for more on the different price multiples). For example, if you suspect that Booking.Com (symbol: BKNG) shares should be trading for a price to earnings (P/E) ratio equal to Expedia’s (symbol: EXPE) shares, then your price target would be equal to Expedia’s P/E ratio multiplied by Booking.com’s trailing earnings. (I cover fundamental analysis in detail in Part 3.)

One word of caution: Don’t set price targets equal to round numbers or whole dollar amounts (like $35, $80, or $120). Many novice traders set their price levels in the same area, which may prevent the security from reaching that price. For example, if you buy a security and expect the stock to face some headwind when it reaches $50, place your limit order to sell shares at $49.83 or a level nearby. Traders who place their limit orders right at the level of resistance and at a round number often are left with unfilled orders.

Swing lows/highs

Swing traders often use prior swing lows as reference points on when to jump ship from a profitable investment. A breakdown below a low may signal the beginning of a new downtrend.

This strategy differs somewhat from the predetermined price target I explain in the preceding section. In that strategy, you set a price target of when to take profits off the table. In this case, however, you use prior swing lows and highs as reference points for when to exit. If you own shares of a security, this strategy calls for putting a stop-sale order below a recent swing low. In contrast, a predetermined price target calls for placing a limit-sell order when the security reaches the area you expected.

Figure 10-4 shows Exxon Mobil (symbol: XOM) from July through October. It illustrates how a predetermined price target differs from exiting on a swing low or high.

In the case of buying shares of Exxon Mobil, you may have set a sell limit order near the prior high of $94 (but not at $94 — use a price below that and not a round number).

Contrast the Exxon Mobil exit to the strategy of placing a stop sell order below prior swing lows in the chart of Sigma Designs, Inc. (symbol: SIGM), shown in Figure 10-5. It shows that by placing a sell stop order below prior swing lows, you can stay in a strong trend longer and reap a larger percentage of the move.

Taking cues from technical signals

In addition to taking profits based off of swing lows, you can take profits based off of technical signals. When using technical signals (flip back to Chapter 5 for a refresher on the various technical indicators), ensure that some crystal clear trigger or catalyst is present that leads you to take profits.

Some examples of selling strategies for profits include:

• Exiting when shares close below a moving average (for example, an 18-day moving average)
• Exiting when the MACD line crosses below the signal line
• Exiting when –DMI crosses above +DMI
• Exiting when prices break an uptrend line

Consider Figure 10-6, which highlights how a swing trader may have taken profits in a trade of shares of W&T Offshore (symbol: WTI). A swing trader may have purchased shares on the turn-up of the nine-day moving average shown in early February. So when should you exit? One possibility: Exit when share prices close below the nine-day moving average. The potential profit — assuming entry and exits near the closing prices on the days highlighted, and exclusive of commissions, taxes, and slippage — is 19.18 percent over 18 days. The stop-loss level (which I delve into in the later section, “Exiting based on a stop-loss level”) should be placed below a recent swing low but not exactly at the low or exactly at a round number.

Stop loss based on a support/resistance level

This first approach to setting your stop-loss level is straightforward. By examining a chart, you should be able to determine levels of support and resistance that, if broken, would signal the end or beginning of a trend. Your job, should you choose to accept it, is to identify a level that’s most applicable to you.

To simplify matters, suppose you’re interested in buying a security. Your stop-loss level should be based around a major support level (preferably, right below that support level). A three-year-old support level isn’t going to have significant relevance most of the time (an exception being if the support level was tested several times during those three years).

In general, a support level is significant the

• More recent it is
• More often it has been tested
• Closer it is to a significant price level ($100, $10, $50, and so on)
• Heavier the volume is on the formation of the support level

Choose important support levels so that you only exit a position when a trend change is most likely. Choosing a weak support level may cause you to exit a position prematurely.

Stop loss based on a technical level

You may exit a position based on a signal from a technical indicator. Dozens of technical indicators can be plotted on a chart, and when one of those indicators gives a signal, an informed swing trader exits.

Technical indicators can be tricky. Just because your technical charting program may have 101 different technical indicators developed by individuals I won’t name here (because I don’t know their names) doesn’t mean you need to use all 101 indicators in your strategy. In fact, professionals often use only a few indicators to make their decisions. Why not use all the bounty with which you’ve been bestowed?

As it turns out, all technical indicators are based on one or two inputs: price and volume. Consequently, there are only so many ways you can peel an onion before you realize those tears are coming out no matter what you do. You don’t get a performance boost from using ten indicators; instead, you get ten people telling you largely the same thing.

Stop-loss orders are sometimes used in conjunction with moving averages. Some swing traders place stop-loss orders right below a major moving average and adjust the order every day or two. Others who use mental stop-loss orders may wait for a security to close below a moving average before taking action to enter an order with their broker.

Figure 10-7 shows a stop-loss order executed based on the nine-day moving average (DMA). A gap up in shares of Yahoo! (symbol: YHOO) in January seemed to be a prelude to a strong uptrend. However, shares of Yahoo! quickly reversed. Setting a stop loss based on a support level may have exposed you to the violent fall, whereas a stop loss based on the moving average would’ve given you an earlier exit.

A stop-loss order can be based on actual signals from a technical indicator (such as MACD). The downside to using such orders is that delays can result. You don’t know for sure what price a security must reach before an indicator will signal its flashing red lights. Using an indicator like a moving average, which is actually plotted on the chart, is helpful because you can identify a specific price before the signal is given.