How to Know ‘How Much’ to Trade With

I’ve got two words for you…

That’s right, just two.

And they’re important — knowing these words could change the way you trade.

Any idea what they could be?

OK, here goes. The words are ‘how much’.

Pause and think for a moment. What comes to mind when you hear ‘how much’?

The typical response relates to profits. People often ask how much money they could make. Others are more cautious — they want to know how much a trade might lose.

Sure, both are important, but they aren’t at the top of the list.

There’s one factor that sits above all others. It’s the single most important decision every trader must make. Getting this right is vital to your success.

So, what does ‘how much’ refer to?

Let me tell you…

It’s all about how much to buy.

Nothing else has as much influence on performance. Trade size is the swing factor that can make or break your career. But it’s an area many people pay little attention to.

Over the next two weeks, I’m going to tell you about trade-sizing strategies. I’ll explain two popular methods that you could use to decide ‘how much’.

But first, a story…

I’m going to give you a behind-the-scenes glimpse of a bank’s trading desk. It may surprise you how many professional traders go about setting their position size.

‘How much’ is more of an art than a science

My first trade for Bankers Trust was in 1992. I remember the lead-up vividly. I’d found a set-up in German bond futures. There was just one problem. I didn’t know how much to buy.

You see, during my training, no one mentioned trade size. It was as if everyone just knew how much to trade. I asked my boss. He simply said to start by risking a ‘few thousand dollars’.

So that’s what I did.

I knew my entry point and stop-loss. I was then able to calculate how many futures contracts to buy.

Easy, I thought…nothing to it.

But it was far from perfect.

The basis of my calculation was several thousand dollars of risk. This figure didn’t have any special relevance. It was just an arbitrary number.

I began watching what other traders were doing. These were some of the best traders in the country. I figured that I’d be able to take my lead from them.

But do you know what?

Many of them were also using a subjective approach to position sizing. They would buy according to their conviction. ‘How much’ was often more of an art than a science.

It took me five years to understand the flaws in this approach. Experience may be a great teacher, but you need plenty of time.

A big issue with subjective position sizing is consistency. Your performance relies heavily on getting the bigger trades right. It only takes a few large losses to ruin an otherwise good year.

Then there’s the question of growth.

Traders naturally want to make larger profits over time. But this requires bigger positions. Knowing when to increase trade size, and by how much, is a challenge for the subjective approach.

So, what’s the solution?

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How to create a systematic process

Well, it all comes down to consistency. You need to remove the guesswork and randomness that many traders are prone too. Only then can you create a systematic process.

The first strategy I’ll tell you about is simple, but effective: the fixed trade size.

You’re probably familiar with this approach. It’s the same method Quant Trader uses. You simply invest the same amount in each stock ($1,000, for example).

Many traders use a variation of this strategy. Instead of using a fixed trade size, they’ll limit their potential loss to a specific amount of capital (this is how I began my trading career).

I like the simplicity of the fixed method. It doesn’t rely on a set of calculations. All you need to do is decide on a standard trade value — this will largely depend on your account size.

Generally, I believe a portfolio should hold at least 20 stocks. This means someone with $20,000 might trade in $1,000 parcels. Brokerage makes smaller trades less practical.

A person with $100,000 has more flexibility. They could buy 100 stocks with $1,000 in each. A good alternative would be hold fewer stocks and increase trade size.

An advantage of larger trade size is a lower effective brokerage rate. For instance, brokerage on a $1,000 trade may be $30, or 3%. But on a $4,000 trade, the percentage falls to 0.75%.

The equal weighting of a fixed trade size creates an even spread of risk. It also ensures you don’t have too little capital in your best trades, or too much in your worst.

OK, let me show you the potential results of this strategy…

Fixed Dollar Trades 07-09-18

[Click to open new window]

This back-test turns a hypothetical $100,000 into over $469,000. And it does this by placing an even amount on each trade — in this case, $1,000. There’s no allowance for costs or dividends.

The system uses the same entry and exit rules as Quant Trader. The only difference is that it only trades signal 1s. The portfolio also has a cap of 100 stocks.

Now, look closely at the chart.

You’ll see the account rises steadily over 24 years. The pullbacks are due to market corrections — not a setback in a single stock. The 370% gain is considerably better than the All Ordinaries.

And remember, this is all from using a consistent trade size.

I often hear people talk about putting more money in big stocks, and less in small ones. This intuitively makes sense. Smaller stocks are often more volatile.

But big stocks aren’t immune to volatility. Anyone with large stakes in the likes of Telstra Corporation Ltd [ASX:TLS] or AMP Ltd [ASX:AMP] would know this well.

Quant Trader’s strategy is to have many relatively small trades of equal size. I believe this is a better way to minimise volatility. No single stock has an overly-large weighting.

Another advantage of consistent trade sizing is profitability.

You see, no one knows which stocks will deliver the biggest gains. A fixed trade size ensures your best trades don’t have the least amount of capital invested in them.

So, this leads to an important question…

How and when should you increase your trade size?

I’ll save the answer for this until next week. This is the second strategy I want to tell you about. I think you’ll be surprised by the difference a plan to gradually trade bigger can make.

Until next week,

Jason McIntosh,
Editor, Quant Trader

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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