Happy new year to you all! I have spent some of the last few days off thinking about my trading and things I need to improve this year. While watching my archive of tapes in the days that I struggle I have found some inconsistency with my tier size. I have seen this problem in a couple of our guys as well so I am sure we are not flying solo here. In this post I want to show you an approach to finding the right tier size for trading.

First we need to start off by having a correct conceptual idea of a tier size. Your tier size shouldn’t be thought of as just the number of shares you are comfortable trading. Let me repeat this, it should NOT be thought of as just how many shares you are comfortable trading in and out of a stock. Instead it should be thought of as your risk management tool. The consistency of your daily numbers depend substantially on the tier size that you use. Your tier size should account for the stock’s liquidity and volatility.

As a risk management tool your tier size should be derived from the amount of risk you are taking in a trade and the amount of money you are comfortable losing on a normal play that doesn’t work out. This latter amount is calculated from your maximum stop loss for the day (see my last post on the correct stop loss) divided by maximum number of consecutive losing trades you experience in a normal day. Holy crap that was hard to write – that engineering side of me definitely came out in that sentence. So let me give you an example so I can wipe out that confused face out all of us.

Let’s assume that your stop loss for the day is $800 and statistically you are rarely wrong more than 10 times in a row (the days when you are wrong 10+ times in a row then you are usually not reading the market well and is time for you to stop). So in this case you should only risk $80 on each play ($800/10 =$80). For this particular example, if you were making a play where your risk is 2 cents then you should consider having no more than 4k shares ($80/$0.02= 4k). If you were making a play in the SPYs and your risk was 20 cents then you should have no more than 400 shares ($80/0.2 =400). You get the point.

The beauty of this approach is that it makes your tier size stock-independent and entirely risk/trade-dependent. This allows you to normalize your results for any kind of liquidity and volatility profile in any stock. And yes it does seem like there is a lot of math to this approach but it really is a simple concept. It does not have to be an exact share count, it just has to give you a ball park number of shares for your trade so that you find consistency in your results. Most importantly, it forces you to have an exit plan for the trade if the stock trades against you. This is specially helpful for those of you who like to jump around stocks with different volatility/liquidity profiles.

Note that so far I have not taken into account the probability of a play working out for our tier size calculation. I want to save this topic for my next post as it requires a lot of attention. For now, think about the approach presented above. I have found it to work quite well for me. Best of luck with your trading this year. -Gman