Using the volatility of a security to determine how much of your money to put into a single trade is a strategy that reduces your risk. Calculating trading size according to volatility is commonly used by people who do a lot of short-term trading, rather than long-term investing. It is a technique that may be applied to stocks, futures, foreign currency (forex) and other types of securities. This approach relies on the fact that greater volatility means increased risk. The specific figures you use to calculate trade size will vary depending on the type of security and your personal trading goals. However, the basic method for determining the trade size for a given transaction applies to any security type.
Decide how much you are willing to lose on a single transaction. Typically, traders limit their losses to 1 to 2 percent of their total portfolio. For example, if you are trading with $20,000 and consider moderate risk acceptable, you might choose 1.5 percent of $20,000, or $300, as the maximum amount you are willing to lose on a single trade.
Calculate the average true range (ATR) of the security. ATR is the average of the daily price fluctuations over a specified time period. For instance, you might want a 20 day ATR for stock trading. Subtract the daily low from the daily high to find the price range for each day. Add the daily ranges together and divide by the number of days to find the ATR. For example, a stock trading at $15 per share might fluctuate $0.75 a day on average.
Multiply the ATR by a factor to allow for normal variation in the security’s trading price range. Traders frequently use 1.5 to 2 times ATR. Suppose you choose to multiply the ATR by 2. If the ATR is $0.75, you end up with an adjusted ATR of $1.50.
Divide the amount you are willing to lose on a single trade by the adjusted ATR for the individual security you are considering. If your loss limit is $300 and the adjusted ATR is $1.50 for a potential stock trade, divide $300 by $1.50. Your trade size would be 200 shares.
Multiply the number of shares (or units of another security) by the current price to find your dollar investment. If the current price of a stock is $15 per share and your trade size is 200 shares. The dollar investment works out to $3,000. In this example, that is 15 percent of a $20,000 portfolio. You’ll want to keep an eye on the dollar amounts since you don’t want to put too much of your money into any one stock or other security.
Subtract the adjusted ATR from the current price. In the example above, that is $15 minus $1.50, or $13.50. Place a stop limit order with your broker when you make your purchase to ensure the security is sold if the price falls enough to reach your loss limit.
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