How to be wrong and still make money. 3 Rules for Managing Your Trades.
Friday, May 4, 2007 | Teeka Tiwari
(Editors Note: This article was originally published on 1/24/2007)
We’ve said it before and we’ll say it again.
If we’ve had any success in this business it hasn’t been because we’ve had a crystal ball or next week's Wall Street Journal.
If we’ve had any success in this business it’s because we follow 3 rules religiously.
Rule #1: Thoroughly analyze the downside risk.
We always know where we are getting out before we get in.
ALWAYS!!
The second part of this formula is successful capital allocation.
Just how much cash should you throw at one idea?
What if you really love an idea. Should you “bet the ranch?”
Here’s our cardinal rule for position sizing:
Rule #2: NEVER RISK MORE THAN 5% OF OUR TOTAL EQUITY ON ANY TRADE.
That doesn’t mean we only invest 5% of our total equity in an idea; it means we’re only willing to risk a maximum of 5% of our principal.
This sounds more confusing than it is. Let me explain.
Let’s say that you have a $100,000 trading portfolio.
We’re not suggesting that you trade in 5% blocks, which would be $5,000 trades.
We’re suggesting that you limit your losses on any trade to no more than $5,000, and that your position size be determined by your stop loss point.
For example, if you saw a stock you liked at $20 per share, and the chart is telling you that $18 is it’s support -- and therefore your stop loss -- you would be able to buy 2,500 shares of the stock.
It’s a $45,000 investment ($22,500 on 50% margin), but you have a predetermined stop loss at $18, which is 2 pts risk on 2,500 shares -- or $5,000.
Remember: POSITION SIZE SHOULD ALWAYS BE DETERMINED BY HOW MUCH YOU ARE WILLING TO LOSE IF THE STOCK HITS YOUR STOP LOSS POINT.
If you never lose more than 5% of your entire investment capital on any given trade, then it is impossible for you to get destroyed by the market.
Rule #3: Pyramid your profits.
What do you do when things go right?
Well there are two ways to play this.
Sometimes we are just looking for a quick 2-4pts, and so when the stock hits our short-term target we simply sell.
Other times though, we’re looking for a major home run. I’m talking about the multi-baggers that can really make your year when you run money professionally.
Here’s how you successfully pyramid into those types of situations.
Let’s take our fictional 2,500 share investment from above that we bought at $20.
It’s now trading firmly above $23, and so we raise our stop loss to $21.
We want to continue to keep our maximum out-of-pocket loss at no more than $5,000, so in this case we can purchase an additional 3,750 shares on margin at $23 per share for a total position size of 6,250 shares at a cost basis of $21.80 ($68,125 on 50% margin).
Now if things go against us and the stock trades to $21, we’ve lost $7,500 on the 3,750 shares we bought at $23, but we’ve made $2,500 on the 2,500 shares we bought at $20 ... leaving us with a very manageable loss of only $5,000 against our principal.
(Forget about the lost paper profits on the first 2,500 shares that we bought at $20. It’s our principal protection that we care about. Profits will take care of themselves if you do a good job minding your principal).
As long as things keep going right in the stock, you can keep right ahead "pyramiding" into the position using your growing equity to finance greater margin trades while all the while limiting your risk to no more than $5,000.
So if the stock now moves to $28 and you’ve moved your stop loss up to $25, you can comfortably pick up an additional 1,650 shares at $28.
If you get stopped out at $25 you lost 3 points on the new lot of 1,650 shares you just bought ($4,950), but you made $7,500 on the 3,750 shares you purchased at $23, plus an additional $12,500 on the first lot of 2,500 shares you bought at $20, for a total gain of $20,000.
Take a look at the 3 year chart on Dade Behring Hldgs Inc (symbol: DADE), and you will see just how simple it can be with the right stock to leverage $100,000 into a multi-million dollar portfolio with very little risk to principal.
Just remember: As your equity grows, so can your position size. But never let your losses on any one position run greater than 5% of your total investment capital.
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Teeka Tiwari
Chief Investment Officer
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