Position Size

A colleague asked me today, "how should I go about balancing my buying power among different stock trades?" I've read a bit on this particular subject, and what I've learned is that it's not so much about balancing 'buy-power' per se; it's more about balancing risk and return.

To do this, we use a simple calculation:
1) Define your risk in dollar terms. Most of the pro's recommend not risking any more than 2% of your equity on any one trade.
2) Chose a worst-case exit price, otherwise known as a strategic stop-loss based on some form of support/resistance (depending on which direction you're trading).
3) At point of entry, divide your risk in dollars by the difference between your entry and exit prices. The result will be the number of shares you can afford to buy at any given level of risk.

Example:
Your equity balance is currently $10,000. The maximum loss you are willing to sustain on any given trade is $200 ($10,000 x 2%). Stock XYZ is currently trading at $1.00 per share. Looking at charts and level 2 quotes of XYZ, you determine the nearest support level to be located at 0.91 - you set a strategic stop at 0.90. Therefore, the largest position you could take in stock XYZ is 2,000 shares [$200 / (1.00 - 0.90)].

A friend of mine at investcanada has recently posted a more indepth article on this topic here. Be sure to check it out!

EDIT: I want to add one thing here; don't forget about correlation! Entering long positions in five different small-caps each with a 2% equity risk tolerance might as well be the same as entering one long position with a 10% equity risk tolerance (2% x 5). We're all familiar with the saying, "a rising tide lifts all boats!"