Ask Colin

Please explain position sizing for me?

The detailed question was:

From reading your book Building Wealth in the Stock Market, I seem to be getting two conflicting messages. On the one hand, you are saying that you need to make allowance for price fluctuation, and not set too tight a stop loss. On the other hand, you are saying to set a stop loss to avoid losing more than 1% of capital. Could you resolve this issue for me?

 

From your question I think you may be not quite understanding what I have been trying to say in the book. You may not have got to the case studies section yet. It may become clearer at that point. The major part of the book is spent explaining my investment plan. This is the theory, if you like to put it that way. However many people do not always find that the easiest way to learn. It was for that reason that I included the major section on case studies and included more case studies on the compact disk that comes with the book. Many readers have given me feedback that the case studies brought the whole thing to life for them. This was my intention. Most of us find actual practical examples resolve a lot of the issues we may not have fully grasped from the discussion in theory terms.

 

What you have described me as saying is not correct. I was not trying to say either of these things. Of course, it is my responsibility as the writer to make myself clear to you. So, I will try to make up for that in the simplest terms that I can as follows:

 

I am not saying that you should set a tight or a loose stop loss. I don’t recall saying that at any point. My whole method is based on trading a trend. A trend is a series of higher peaks and higher troughs on the price chart. I buy into an upward breakout on the assumption that a trend will unfold. Or I buy into an existing uptrend. I hold while the trend is intact. The key feature of a trend for this purpose is that each trough in the trend forms at a higher price than the previous trough. If the price falls through the previous trough, then the trend has failed by definition. This is therefore where my stop-loss is – under the accumulation or consolidation pattern for the breakout and under the last trough in the trend once it begins to unfold. This is really simple. So simple, in fact, that some people have actually asked me if I run an advanced course where I say what I really do. The good news is that this is what I actually do and all that I do. There are no undisclosed secrets. In The Aggressive Investor I have disclosed everything that I do.

 

So, that is how I set where my stop-loss will be. Under the lows of the accumulation or consolidation pattern at breakout and under the last trough in the trend once the price is trending.

 

The remaining issue is where 1% of capital comes in. I can not stress highly enough, and I hoped that I had made clear in The Aggressive Investor, that I set my stops based on the trend. I do not, repeat not, ever for one moment set the stop any other way. In particular, I do not buy a quantity of shares and set the stop at a price that means my loss would be 1% of capital. This is getting it all the wrong way about. Even worse, that is a recipe for disaster. If you set a stop above the last trough in the trend you are inviting normal price action to take you out and then the trend carries on without you. The result is that by setting the stop in this way, you have increased the risk of making a loss. If this is what you have been doing, for heavens sake stop doing it. It is not right and it is not what I am teaching.

 

 

What I do is this:

 

I look at the bid-offer spread and decide my buying price.

 

I work out where my stop-loss should be as described above.

 

I subtract the stop-loss level from the entry price.

 

That difference is my risk per share

 

I take 1% of my capital (all holdings at market price plus cash reserve).

 

I divide that number by the risk per share.

 

The result is the number of shares that I can buy and only lose 1% of capital if I am wrong and my stop-loss is hit.

 

Example:

 

Entry price $3.00

 

Stop-loss level $2.10

 

Risk ($3.00 - $2.10) 90c

 

Assume my capital is $100,000

 

1% of capital is $1,000

 

$1,000 ÷ 0.90 = 1,111 is how may shares my method allows me to buy, holding my potential loss to no more than 1% of capital.

 

Please study this simple example. Then work your way through the case studies in my book. Once you have mastered this concept I think you will improve what you are doing now.

 

Thank you for asking this question. You are not the first to ask it. I appreciate the opportunity to try to explain it to you better. I hope I have succeeded.

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