Position Risk

March 17, 2010 at 6:50 am · Filed Under Educational 

If I bought 1000 shares of INTC at $19, how much am I risking?  $19 x 1000 shares = $19k invested, but that’s not how much I’m actually risking.  In order for me to lose $19k on this position, INTC would have to drop to $0 overnight.  Even Enron couldn’t pull that off.

The real answer requires a little more information, like where my stop loss is set.  Let’s look at the following breakout:

image

Regardless of where I enter the stock, my stop loss would probably be somewhere around $15.  Let’s look at 2 scenarios.  For the first, say I got a good entry of 1000 shares at $17.*  I’m risking $2 a share on 1000 shares, giving me a risk of $2000.  For the second, say I jumped on late and entered at $19, giving me a risk of $19-$15 on 1000 shares, or $4000.  Purchasing the same number of shares on the same stock, I risked twice the amount in the second scenario.

Most people will determine how many positions they want to hold, look at how much capital they have, and then just allocate an equal amount to each position.  For example, I want 4 positions, I have $100k, so I’ll put $100k / 4 = $25k in each position.  What you really want to do is set a constant risk across your positions though.

To even out my INTC scenarios, I would have to buy half the amount to get my risk back down to $2000 in the second case, or 500 shares.  But doesn’t that mean I’ll only make half as much money when it goes up?  Yes!  That’s why it’s important not to buy overextended stocks. Either your risk will go up or your reward will go down, and I think you know which way you want that scale to tip.

Once you get a grasp of risk sizing your positions, you’ll see that buying KO can be just as risky as buying some hot biotech company or even more risky than call options on a Chinese solar firm (risk is easy to determine on call options since it’s actually 100% of your investment). †   I’ll have more on this in a post about risk, reward, and capital in the future.  If the gap between my last educational post and this one is any indication though, don’t hold your breath waiting for it…

* Yes, I know this is a weekly chart and INTC actually gapped through this price.  Ignore the symbol and just look at the chart and numbers.

† This ignores the fact that stocks can gap down through your stop, but slippage is a topic for another post.

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