Trading With Less Capital
Stockscores.com Perspectives for the week ending November 24, 2013
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In this week's issue:
Stockscores Market Minutes Video
Once you understand risk, tolerance for risk and how to size positions, you can really judge whether a strategy is worth trading. This week's Market Minutes shows you how, watch the video on Youtube by clicking here.
How to Find and Profit from Hot Stocks video
I have recorded a video version of my recent stock trading workshops, watch it now on Youtube by clicking here
Bang For Your Buck
A Stockscores user asked me a question that I think many people have, "If you have more trade opportunities than capital, how do you pick which trades to take?"
The short and simple answer is to take the trades that give you the most bang for your buck. Let me explain.
We size our trade positions based on the risk of the trade. The risk of the trade is the difference between the entry price and the stop loss price. Divide the risk in to your risk tolerance amount and you have the number of shares you can buy.
Consider two trade possibilities, each with strong charts that show the same potential for price appreciation. The first has an entry price of $5 with support, and therefore our stop loss point, at $4.50. That means there is $0.50 of downside, or the potential for a 10% drawdown.
The second trade has an entry price of $20 with a $19 support price and stop loss point. On this trade, if wrong, we stand to lose $1 per share or 5% drawdown, since $1/$20 is 5%.
If we are willing to risk $500 on each trade, we will buy 1000 shares of the $5 stock for a total cost of $5,000 and 500 shares of the $20 stock for a total cost of $10,000. Each trade has the same amount of risk but the second trade requires more capital because the stock is less volatile. That also means the expectation for percentage gain on the second position is also less. The price volatility on the entry signal is a good predictor of what price volatility will be in the trend.
Clearly, the first trade gives more bang for the buck. We can use less capital for the same profit potential. We may believe both trades have the potential to make $1000 but the first trade will do it with half as much money invested. For a trader with limited capital, the first trade is the one to take.
Generally, lower priced stocks will be more volatile on a percentage basis, making them a source of greater percentage gain potential. You can place less capital in to a low priced stock to get the same dollar upside as a higher priced stock trade.
I did a quick survey of this week's best gainers to confirm this fact. I ranked the 2000 most actively traded stocks in the US last week by percentage gain and focused on the top 20 gainers. Of the top 20, 17 were under $10. The other 3 were under $20.
The lesson here is to focus on lower priced stocks if you have less capital to trade with. Many will argue that these lower priced stocks are riskier and maybe dangerous for a risk averse trader. They are actually not riskier, they are more volatile. That means you have to take a smaller position size in them so that the risk of the trade does not exceed your risk tolerance.
By adjusting position size based on the difference between the entry price and stop loss price, you can make every stock trade have the same amount of risk. If the stock is volatile buy less. If your amount of capital is insufficient for all the trades you find, focus on the lower priced stocks.
There is one caveat to this style of risk management. Lower priced stocks tend to have an added element of risk because they have a greater potential for price gaps. Lower priced stocks tend to have less established or diversified businesses which means a problem with one of their businesses can have a major impact on share price. It is much easier for a small Biotech stock to gap down 30% on bad news than it is for Pfizer to. That means the low priced stocks you trade could blow through your stop loss point if bad news brings a big price gap.
That makes it important to not put all of your capital in to just a few low priced stocks. If you are going to focus on relatively cheap stocks then you must own a number of them so that a larger than expected loss on one of them does not bring your portfolio performance down significantly.
If you have less capital to trade with than what you would like, focus on the lower priced stocks. You can adjust your Stockscores Market Scans to include a price filter for stocks under $10 or even lower if you like. Just remember to size your positions based on the volatility of the stock, the difference between the entry price and support on the chart, where you will put your loss limit. By doing that, you can match the risk of the trade to your risk tolerance and use less capital to gather the same dollar profit potential.
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This week, I looked for stocks under $10 that had made an abnormal gain on Friday with abnormal volume and traded at least 300 times. This produced 15 results which is lower than this sort of scan will usually find.
I inspected the charts in search of stocks that were breaking from optimism but early in a trend, moving out of a period of low price volatility. I want to see an abnormal break from a good chart pattern because that is a reliable indication that the stock can go in to a strong upward trend.
I did not find anything that I liked.
So, this week's lesson is to show a few charts and describe why I don't like them. I find that my students are never fussy enough when they start looking at charts. We should only take good pattern set ups and ignore those that have problems. The stocks below are examples of charts that have patterns:
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1. PLM
The six month chart of PLM looks pretty good, breaking from sideways trading through resistance. The issue shows up when you lengthen the time frame to a 3 year weekly chart and see the strong resistance at $1.20. With an entry at $0.95 and support at $0.75, there is $0.20 of downside risk and $0.25 of upside to resistance. I like to have at least twice the upside as downside.
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2. PVG
PVG had a 81% jump on Friday, a strong sign that the market likes the company changing fundamentals. The problem is that the market has been so pessimistic about this company for so long. The people who have been buying this stock as it fell over the past 3 months are frustrated and will likely sell in to strength as the stock approaches a breakeven price for them. Too likely that the strength will fizzle out quickly although a day trader may find some opportunities for quick trades in the short term.
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3. GST
GST has been strong for a while and that is the primary problem. Buying the stock here is buying retail, buying with the general public. Since the stock has been going up for most of 2013, it is one you want to consider on pull backs to its upward trend line but not on days when it runs up and away like it has this week.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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