Does it make sense to buy more stock when one feels strongly about the expected result? What is the 'normal' amount of stock to buy? How does the investor determine how much stock to purchase? This article suggests a relatively simple way to control risk through bull and bear markets.
J. Wiles Wilder, in his 1978 book, New Concepts in Technical Trading Systems, recognized that bull and bear turning points are characterized by increasing levels of volatility. Volatility can be characterized by the widest range of price between yesterday's close, today's open, the intraday high and the intraday low. For a stock that closed yesterday at 14 but opened today at 13.75, dropped to 13.5, rallied to 15 and closed for the day at 14.75 we measure:
and find that the daily atr is 15 ( the high) minus 13.5 ( the daily low) or 1.5. This is the true daily range. The daily range is usually collected into an exponential moving average ( Wilder recommends 14 days) and becomes the average true range oratr
So how does this help compute our stock quantity? Suppose we have a portfolio of $100,000 to invest and we always allocate 1 percent of our investment portfolio or $1000 to the risk we willingly encumber on any one stock. We find a stock we wish to purchase that is trading at $20 dollars a share. The 14 day atr is 1.5. When volatility is low we buy more shares. As volatility rises we buy less.
Thus, we would expect the stock under ordinary circumstances to trade between $19.25 and $20.75. Any greater price movement is more likely to be considered a change in direction, not daily variability. We have a measure we can employ to separate risk of an adverse market movement from normal volatility.
Going back to our example, if we wish to risk $1000 we can buy 667 shares of stock and be willing to let the stock price drop to $18.50 before our stop is effective. Or we can buy 333 shares but our stop is only $17. Thus, the larger the number of shares purchased the less volatility we can absorb and still honor our 1 percent risk limit.
While collecting the data to compute the atr is tedious there are many websites including Yahoo finance and MS Money that have tools that readily calculate the atr. Any search engine can find many other sites that calculate atr and are easy to use.
It is recommended that the investor employ more than a one atr stop. In the case above this means an atr of 1.5 ( 1.5 times 1atr) be used. This is because the additional volatility eliminates many intraday whipsaws when the stock happens to be purchased at the high of the day or temporary market reaction adversely affects the stock for a few hours. The cost of increasing risk protection is to reduce the number of shares purchased but it is a reasonable safeguard given the transaction cost of whipsaws and the vagaries of intraday stock movements.