Position Management: Have a Plan and Stick to It

A Note from Keith: Today we’ll wrap up our special four-part series, “Foundations of Wealth.” After careful consideration, I’ve decided that today will be the last Money Talks article for a while as we look to focus on some new and exciting endeavors. I wanted to share my sincere gratitude for your support, readership, and feedback over the years. You can continue to hear from me regularly through the TradeSmith Daily e-letter. (If you aren’t subscribed, you can sign up for free right here.)

In my previous essays, I described the importance of asset allocation (the mix of assets you buy) and position sizing (how much you buy).

In this essay, I’ll talk about how — before you buy anything — you should have a plan for how you’re going to manage that investment.

Just for a moment, I want you to think of a bizarre situation.

You get in your car and head to the supermarket.

You have to pick up groceries for dinner.

After you get on the road and pick up speed, you go into a panic…

…because you just noticed there’s no brake pedal.

You have no ability to stop or slow the vehicle.

Then, you panic even more when your steering wheel locks up.

You have no ability to steer the car.

Now, you’re in a car with no brakes and no functional steering wheel. You’re in motion and in danger.

Of course, this wouldn’t happen in real life.

But this bizarro situation is how most people manage their investment portfolios.

It’s how most people manage their stock and option trades.

They get into investment and trading positions with high hopes and a destination in mind, but no ability to manage the positions once they are live.

The way most people trade and invest is the equivalent of the driver with no ability to change direction or stop the car.

No plan and pure panic — pure financial illiteracy.

As we covered earlier, most investors focus on investment entries.

They focus on what to buy. They focus on stock picks.

However, the decision to enter an investment or trade is just one small part of that financial undertaking.

We already covered how position sizing is a big part of investing: How much money you’ll allocate to an investment or trade.

Another big — and sadly, underappreciated — part of investing is called “position management.”

Position management is what you do with an investment or trade after you’ve gotten into it.

It’s how you’ll steer the car and adjust its speed while it’s on the road.

For example:

• If you buy a stock that you believe has the potential to triple in value, but instead it sinks 22% in value, what will you do?
• If you buy a stock that soars 50% right after you buy it, but then declines back to your purchase price, what will you do?
• If you buy stock in a company with a highly respected CEO at the helm and that CEO steps down, will you sell the stock?
• If you buy a stock that rises 100%, what kind of plan do you have to preserve that solid gain?

These are the questions and the kind of planning skilled investors and traders do as part of their process. They give exit planning a lot of thought.

Unskilled, undisciplined investors barely give this planning a second thought.

They put large amounts of their hard-earned savings at great risk by entering investments and trades while having no exit plan.

No exit plan in case the stock heads 20% lower after the purchase.

No exit plan in case the stock rises 100% after purchase.

No exit plan in case the stock rises 20% and then drops back down to the purchase price.

It happens every day the stock market is open.

And it’s totally crazy.

As you might expect, the world’s best investors and traders — the “haves” — give exit planning A LOT of thought. They know in advance what they will do if a stock or a trade soars in value. They know in advance what they will do if a stock or trade sinks in value.

They plan ahead.

Instead of acting like the financially illiterate investor who is flying down the road with no brakes and no steering, smart investors create a plan in advance — and they stick to that plan.

For a lot of great investors and traders, a key part of that plan is a powerful financial tool called a stop loss.

A stop loss is a predetermined price at which you will exit a position if it moves against you.

It’s your “Say ‘uncle’” point.

It’s when you say, “Well, I’m wrong about this one, time to cut my losses and move on.”

Most people use stop losses that are a certain percentage of their purchase price.

For example, if an investor purchases a stock at $10 per share, he could consider using a 20% stop loss.

If the stock goes against him, he would exit the position at $8 per share — 20% lower than his purchase price.

If that same investor uses a stop loss of 25%, he would sell his position if it declined to $7.50 per share, which is 25% less than $10.

A stop loss of 5% is considered a “tight stop loss” — one that is close to your purchase price — and a 50% stop loss is considered a “wide stop loss” — one that is a long way from your purchase price.

Stop losses can work hand-in-glove with position sizing to greatly increase your odds of success in the markets.

To get these two powerful tools working together, we need to get familiar with something we call the “risk level.”

Your risk level is the amount of money you will “risk” on any one given investment.

It can serve as the foundation of all your position-sizing and exit strategies.

For example, let’s say there’s an investor named Steve with a $100,000 account.

Steve believes Company ABC is a great investment and decides to buy it at $20 per share.

But how many shares should he buy?

If he buys too many, he could suffer a catastrophic loss if an accounting scandal strikes the company.

If he buys too little, he’s not capitalizing on his great idea.

Here’s where intelligent position sizing comes into play.

Here’s where the investor must calculate his risk level.

The risk level is calculated from two other numbers.

One is total account size; in this case, it’s $100,000.

The other number is the percentage of the total account you’ll risk on any given position.

Let’s say Steve decides to risk losing 1% of his $100,000 account on the position.

In this case, his risk level is $1,000.

If he decided to dial up his risk to 2% of his entire account, his risk level would be $2,000.

If he was a novice or extremely conservative, he might go with 0.5%, or a risk level of $500.

Steve is going to place a 25% protective stop loss on his Company ABC position.

With these two pieces of information, he can now work backward and determine how many shares he should buy.

Remember: Steve’s risk level is $1,000, and he’s using a 25% stop loss.

To calculate how large the position will be, the first step is to always divide 100 by his stop loss.

In Steve’s case, 100 divided by 25 results in 4.

He then takes that number — 4 — and multiplies it by his risk level of $1,000.

4 times $1,000 is $4,000, which means Steve can buy $4,000 worth of Company ABC stock, or 200 shares at $20 per share.

If Company ABC declines 25%, he’ll lose $1,000 — 25% of his $4,000 — and exit the position.

That’s it.

That’s all it takes to combine stop losses and intelligent position sizing to limit risk.

Here’s the calculation again:

100 divided by your stop loss equals “A.”

“A” multiplied by “risk level” equals position size.

Finally, position size divided by share price equals the number of shares to buy.

Now, what if Steve wants to use a tighter stop loss — say 10% — on his Company ABC position?

Let’s do the math.

You can see that using a tighter stop loss with the same risk level allows Steve to buy a larger number of shares, while risking the same amount of his total account: $1,000.

Next, let’s say Steve wants to use a super-tight stop loss of just 5% on his position.

In this case, if Company ABC declines just 5% to $19 per share, he’s out of the trade.

This tighter stop loss means he can buy even more shares.

Let’s do the math again.

Again, a tighter stop loss with the same risk level of $1,000 means he can buy twice as many shares and still risk the same amount of his total account.

As you can see, you can use the concepts of position sizing and stop losses to determine how much of any asset to buy, from shares of Apple to shares of Home Depot or a commodity like copper or crude oil.

If you’re investing in or trading a riskier, more volatile asset, the stop-loss percentage should typically increase and the position size should decrease.

If you’re investing in a safer, less volatile asset, the stop-loss percentage should decrease and the position size should increase.

To be clear, you DON’T have to use stop losses with your investments.

You can simply use no stops but small position sizes.

If you put on a $5,000 position with no stop loss, you’re taking on the same amount of risk as if you put on a $10,000 position with a $5,000 stop.

You’re risking $5,000 either way.

Many professionals combine no stops and small position sizes with riskier, more volatile investments, like private companies, micro-cap stocks, options, and cryptocurrencies.

We could spend a lot of time going over different kinds of exit plans for different kinds of investment outcomes.

But we want to keep things quick and simple for right now.

We want to focus on the core, foundational idea: Have an exit plan — and stick to it.

The best thing about exit planning is that it leads to higher-quality decisions than “winging it ” does.

Managing your money is stressful. After all, it’s your hard-earned savings and financial freedom on the line.

We all know the decisions we make under stress are likely to be of lower quality than the decisions we make when we’re relaxed.

When we are in a big hurry or when we’re angry or dealing with a traumatic event, the rational part of our brain doesn’t work as well. It can even seize up and put us in a frozen state.

Now throw in the stress of managing our money.

Do you really want to “just wing it” when it comes to these critical decisions?

Do you want to make up your plans on the fly when you’re rushed and under a lot of stress?

It’s a no-brainer.

It’s a no-brainer to have a preplanned exit strategy for every investment or trade.

I can’t state this emphatically enough.

Creating an exit plan for every investment and trade you make is a major difference-maker in your financial life.

It’s one of the major things that separates the financially literate from the financially illiterate.

The financially illiterate are very prone to “winging it.”

Most of the time, they buy investments or enter trades with no exit plan.

Their decision-making is pure chaos.

There’s no plan and there’s no rhyme or reason. The just make it up as they go along.

This leads to a lot of low-quality decisions made during times of stress.

But don’t take it from me… take it from one of the most stressful pressure-cooker jobs on the planet: Being an NFL head coach.

Being an NFL head coach during a big game is one of the most stressful activities on the planet.

There are many millions of dollars on the line.

There are a lot of people watching and scrutinizing every move you make.

You’re working with extremely competitive, extremely aggressive people who are also under stress.

And during games, coaches must make big decisions with very little time to think about them.

It’s an intense mixture, a real “stress cocktail.”

Given the stress of coaching an NFL game and the complexities involved, it’s no surprise that head coaches are HUGE on pre-planned decision making.

This is a massive thing every coach learns early on in their career: Have a plan for every kind of situation. Know in advance what you will do. There’s a lot on the line, so for goodness sakes, don’t “wing it.”

During every game, coaching staffs have on hand big lists of potential situations they could face plus their pre-planned moves they will make in those situations.

They know what they will do in each situation before it even happens.

After all, it’s very hard to make great decisions on the fly and in a hurry when so much is on the line.

There’s too much on the line to “wing it.”

For example, if you’re down by 4 points and there’s 40 seconds left and you have the ball at the 50-yard line, what do you do?

Coaches have a plan for that.

The team has practiced what it will do in that situation.

Or, if a team is up by 1 point after scoring a touchdown in the fourth quarter, do they kick an extra point or go for a two-point conversion?

Coaches have a plan for that.

They’ve done the math and created a strategy in advance.

They don’t wing it. There’s too much on the line to wing it.

Managing your money should be no different.

Your money is too important to “wing it” with your investments and trades.

You should give yourself the advantage of knowing what you’ll do in a given situation in advance. Give yourself the advantage of higher-quality decisions made with plenty of time to think and when you’re in a calm state. I know exit planning isn’t as exciting as buying a small stock with major potential or making a bet on a new industry that could explode in size. But this is the stuff masters spend their time and focus on.

This is the stuff that truly matters.

This is what the financially literate focus on.

This is what ensures your portfolio is built on a solid foundation.

If you don’t spend time on this part of your investing or trading, then you’re not serious about achieving success.

It’s that simple.

If you’re not ready to spend time and energy on exit planning, you’re not ready to win — and you’re choosing to be financially illiterate.

You’re choosing to put yourself in the position of driving that car with no brakes and no steering.

The people that are serious and are willing to put in the work will eat you alive.

Summary

By now, I hope you see that spending most of your time and energy on stock ideas is an amateur move.

It will hold you back and increase the time it takes for you to achieve your financial goals.

Obsessing over stock picks is one of the hallmarks of financial illiteracy.

Instead, I hope you focus on what really matters. Focus on building and maintaining your strong financial foundation.

Become a master at asset allocation, position sizing, and position management.

Those are the parts of your investment strategy that will move the needle.

Those are the things the financially literate focus on.

These are by far the most important factors in your success as an investor.

These are the concepts you must master if you want to achieve lasting success as an investor or trader.

These are the concepts that separate the haves from the have-nots.

These are the concepts that will make you financially literate and then take you to “master” level. Most of your time and energy as an investor should be spent learning and applying these super powerful ideas.

At TradeSmith, we’ve spent more than $18 million and over 11,000 man-hours developing software tools that make it easier than ever to master and utilize the foundational components of smart investing and trading.

We’ve made it easier than ever to employ smart asset allocation.

We’ve made it easier than ever to size positions intelligently.

We’ve made it easier than ever to use smart exit plans.

Your success is important to us.

And I don’t mind sharing that there’s some self-interest here on my part. I won’t deny that.

The way I see it, the more of your investment or trading gains you retain and the more losses you keep small, the more money you’ll make and the better your experience in the markets will be… and the more likely you’ll be a long-time customer of ours.

We hope to play a role in helping you achieve your financial dreams as quickly and as safely as possible.

We’ll be there every step of the way.

Did you miss the previous essays in this series? Read the introduction here; learn about asset allocation here; and learn about position sizing here.