Editor’s Note: Karim’s fundamental article on risk and position sizing fits perfectly in today’s climate of market uncertainty. While the market has been fairly positive for the last few weeks, with COVID-19 on the rise and election uncertainty looming, you don’t want to get caught with your pants down. Check out one of our favorite articles on risk and what you can do to limit losses in your portfolio.
– Ryan Fitzwater, Associate Publisher
It’s only during down markets that investors think about risk. And by then it is way too late.
It’s akin to calling an insurance agent when your house is on fire and asking about that policy you should’ve renewed!
I bet that for every thousand investors who lose their shirts in a down market or when a particular stock tanks, there is just one savvy investor who prepared. The ratio may be even worse! The thing is, you want to be that one who prepared.
There are quite a few ordinary ways to prepare for a down move, and there is one great way.
It’s position sizing in combination with a stop loss. A stop loss is when you designate a specific price at which you will sell a stock if it reaches that level. It prevents you from taking a bigger loss than you want. For example, if you buy a stock at $10 and set a 25% stop loss, you are agreeing to sell the shares at $7.50 if they move lower. You lose 25% of your original investment and no more.
But just having a stop loss is not enough. Not by a long shot. A stop loss doesn’t keep you from losing the ranch if you happen to bet the ranch on a particular stock. That’s why position sizing is important and the combination of the two is unbeatable.
You should not put more than 4% of your investable portfolio into any one position. For example, if your portfolio is worth $1 million, $40,000 is your maximum investment in a single position.
Then you apply a 25% stop loss to that position. So if your investment is $40,000, you would sell out of your investment if the stock fell by 25%. That would leave you with $30,000 in cash. But more importantly, your total portfolio would suffer only a $10,000 loss, or 1% of $1 million.
Of course, these numbers are not exact and will depend on market conditions and the size of your portfolio. But you get the gist. You want to limit your total portfolio loss as well as the potential loss in each individual position.
Action Plan: Is it a perfect strategy? There is no such thing. The worst thing that can happen is the stock falls either premarket or postmarket by more than your stop loss or to a number below your stop loss. This will not happen frequently, but it’s possible.
However, you’ll always sleep soundly knowing that, the vast majority of the time, your loss on any single position will ding your overall portfolio by 1% at most. And using a stop loss will force you to become a disciplined investor and prevent you from falling in love with a stock or a story. For more insight on risk, position sizing and how you can limit losses, join me in The War Room today!
About Karim Rahemtulla
Karim began his trading career early… very early. While attending boarding school in England, he recognized the value of the homemade snacks his mom sent him every semester and sold them for a profit to his fellow classmates, who were trying to avoid the horrendous British food they were served.
He then graduated to stocks and options, becoming one of the youngest chief financial officers of a brokerage and trading firm that cleared through Bear Stearns in the late 1980s. There, he learned trading skills from veterans of the business. They had already made their mistakes, and he recognized the value of the strategies they were using late in their careers.
As co-founder and chief options strategist for the groundbreaking publication Wall Street Daily, Karim turned to long-term equity anticipation securities (LEAPS) and put-selling strategies to help members capture gains. After that, he honed his strategies for readers of Automatic Trading Millionaire, where he didn’t record a single realized loss on 37 recommendations over an 18-month period.
While even he admits that record is not the norm, it showcases the effectiveness of a sound trading strategy.
His focus is on “smart” trading. Using volatility and proprietary probability modeling as his guideposts, he makes investments where risk and reward are defined ahead of time.
Today, Karim is all about lowering risk while enhancing returns using strategies such as LEAPS trading, spread trading, put selling and, of course, small cap investing. His background as the head of The Supper Club gives him unique insight into low-market-cap companies, and he brings that experience into the daily chats of The War Room.
Karim has more than 30 years of experience in options trading and international markets, and he is the author of the bestselling book Where in the World Should I Invest?
