Many people ponder the same question when it comes to investing in individual stocks. How much capital (cash) should I allocate to a particular stock or exchange traded funds (ETFs)? This guest post might be able to answer some of your questions about risk management of stock investment.
Now your local financial advisor might show you dozens of pie charts featuring “model portfolios” and throw in a little personal opinion, which very well may satisfy you. For now.
What they aren’t telling you is that you’re asking the wrong question!
The real question can’t be answered by any stock broker, financial advisor, or even Warren Buffett himself, but rather it’s an internal one that each of us have to answer for ourselves. (Plus you’ll save yourself $50 an hour for advice!)
How much am I willing to lose?
It may sound “wrong” or even “dirty” to think about the downside of a trade/investment, but the preservation of capital is just as or more important than how high a particular stock might rise. Before taking a position in any stock, you need to know your “I’m wrong level”.
How do I determine what I’m willing to risk?
The worst possible thing anyone can do is buy a stock and then determine the “I’m wrong level”. Past experience will tell us that level will drop as quickly as XYZ stock drops. We as human beings don’t like to admit when we’re wrong, but know that pride can only be an enemy when you’re trying to navigate the stock market.
This is not a family vacation where you are lost and won’t pull over to ask for directions, this is real money we’re talking about! So start out will a low risk tolerance on each trade. It’s a lot easier to start out small and build your position size up, than the other way around.
Key point: Just because you consider yourself as investor in individual stocks or ETFs, doesn’t mean you can’t you use the following risk management plan (or a similar one). Complimenting fundamental analysis with technical analysis will only make you and I better prepared to take on the volatile world of stocks.
For example, if Apple (AAPL) has 10% downside risk (10% above the current support level), we as risk managers need to respect that. So let’s say that we have a $200,000 portfolio and want to hold up to 10 positions, using $2,000 as the maximum risk in any particular equity.
By using this approach, you can either buy $20,000 worth of (AAPL) shares with a stop loss slightly more than 10% under the current share price or you could put on an options strategy (buy calls, call spreads, or call butterflies) for a $2,000 debit.
Stop losses are a way to cut losers early without pulling the trigger yourself. The sell order is automatically placed once the stock price hits your desired stop loss level.
Stock or options?
Options by definition are a risk manager’s friend. Using our example above, instead of putting $20,000 of capital in Apple, we could put on an options trade and not have to worry about the underlying shares falling 15% overnight, making our stop loss irrelevant. The most our options strategy could lose is the $2,000 debit, while we could wake up to losses of multiply times what we were originally willing to risk in the event of a disappointing earnings report, downgrade, etc.
Extrapolating that to our original thesis, we could risk as little as $20,000 in capital to manage 10 different positions in the hypothetical $200,000 portfolio. Doing so leaves us with $180,000 in cash in the event of a large sell off in the market, or 90% of the initial capital.
4 Main Points on choosing options or stocks
- Skill Level– Someone who is new to the stock market is unlikely ready to trade options.
- Trade- A trader is looking for shorter term moves, so an options trade that only goes out for a couple of weeks or months will typically have a low capital outlay, making options a favorable choice.
- Investment- If you plan on holding a position for several months or years, stocks are your likely preference. Look to trim a stock position (1/4, 1/3, or even 1/2) near resistance and add it back near support, while raising stop losses as the price moves higher. Another way would be using deep-in-the-money calls as a stock replacement strategy.
- Catalysts- Buying something before or holding something through a major catalyst (earnings report, new product, etc.) can be detrimental or beneficial depending on the outcome. Options can give you the necessary low risk, high reward potential to maintain a position through volatile periods. Also, there is nothing wrong with just closing out a position ahead of a major catalyst. We’re not trying to show how macho or brave we can be.
Once you’ve accessed the downside exit of a potential trade, there is one major piece left to figure out before a trade is taken. Your upside exit point needs to be determined in order to find the reward/risk ratio. If Apple shares are 10% above current support and it has a potential 34% gain before running into major resistance ($600 level), (AAPL) has a favorable 3.4:1 reward/risk ratio.
However, if that ratio were flipped to 1:3.4, then the odds aren’t in favor of someone who is long (buying) Apple shares (or calls). Of course you can always use dollars per share instead of percentages and get the same ratios. As a rule of thumb, only look to take trades with a 2:1 reward/risk ratio or better on either long or short ideas.
By adding these small steps to your investing or trading plan, you can increase your profitability and improve your winning percentage by being “picky” on when an entry is taken. No matter how long someone has been investing or trading, he or she can always exceed their current results by adding a well-defined, disciplined approach to the stock market.
What is your approach to trading and investing in individual stocks and ETFs? Leave us a comment below sharing your strategy.
About the Author – Mitchell Warren is founder and CEO of Options Risk Management. He has traded stocks, options, and futures for seven years, with a primary focus on technical analysis and unusual options activity.