…It’s what you do with it that counts. That’s what they say, right? Nonsense. Size matters. A lot. At least when it comes to trading. It matters for two reasons.
1) Travel Range
The average travel range (or ATR) of a stock is a measure of how far, on average, its price moves in a given time period. To put it another way, it’s a measure of the difference (on average) between the highest and lowest prices the stock reaches in a given time period.
As day traders, we’re interested in the intraday timescale, so in terms of ATR we would be measuring it on a 1-day timeframe. In other words we are concerned with how far, on average, a stock moves in a single day.
Given that we’re not looking to buy and sell tops and bottoms (that’s hard and risky), but rather trade what I call the easy middle, the bigger the range the easier it will be to grab a chunk of a move. The bigger the move, the smaller the chunk we need to catch for it to be worthwhile.
For example, if a stock regularly moves $10 in a single day, we could catch just 10% of that range to make a dollar per share. Assuming we’re trading 1000 shares, bang, we’ve grabbed a grand profit by taking a small chunk of the day’s price move…the easy middle. If a stock only moves on average $1 a day, we would have to capture 100% of that range to make the same amount of profit. Trying to capture a small part of a big move is clearly easier.
A lot of traders get hung up on ATR, studying historical charts and analyzing the indicator over multiple timeframes. I’m lazy though, I like an easy life. I don’t bother with that. When I build my watchlist, I use a simple filter: I preference stocks that are priced above about $20. The reason is simple; if we consider the ATR as a percentage of the price, a cheap stock is going to have to move a vast amount relative to its price to have a worthwhile travel range. If we wanted a range of at least a dollar, a $10 stock is going to have to move 10% for that to happen, whereas a $100 stock only has to move 1%. Typically (and you’ll notice that I’ve just used another generalization there), we see more 1% moves in the stock market than 10% moves.
To summarize travel range then, as a rule of thumb higher priced stocks don’t need to move as far in percentage terms in order to give us ‘easy’ trades. So size in terms of price, is important. It’s a factor to take into account when building a watchlist. Yet as with everything, this rule is a guideline and can be broken. Also: there’s a catch with higher priced stocks. Which leads us nicely to…
2) Position Size
Having read the above, we might wonder why $20 should be the cut-off point for selecting stocks. We could be tempted to look only at those priced above $100 or more.
But here’s the catch. To buy 1000 shares of a stock priced at $100, we need at least $25,000 in our trading account ($100 x 1000 = $100,000 / or $25k at 4:1 margin). If we bought the same number of shares in a $10 stock, we would need just $2,500.
This is one reason why we keep the minimum price relatively low. The other is that if we choose carefully, there’s actually no shortage of relatively cheap stocks that move well over a dollar or more in a given day, just as there are lots of expensive ones that barely budge an inch.
Despite the catch then, cheaper stocks offer an interesting advantage. Assuming our account is suitably funded, we can trade much larger size of a lower priced stock, thus amplifying the profit from that stock (and amplifying any losses, too). Which brings me to the trade I wanted to post today.
This stock is well below my $20 guideline, but I bent the rules because it showed every sign of making a nice move. As we can see, I was not disappointed:
There was actually an early entry for anyone who wanted it, but I missed that. Still, the missed move was a signal that there could be more to come. And come it did, dropping nice and fast over a period of about ten minutes. The exit was when momentum fell away. Ultimately that was a brief pause and there was another move, but I was out with my profit by then.
As we can see from the chart, I didn’t need to get in early, or try to ride it right to the very bottom. I took the easy middle bit, the clearly signaled, low risk drop that provided me with 77 cents profit for each share I had shorted. And because the price was so low, I could trade a 2000 share position, giving a total profit of $1,540 for the trade.
Keeping It Simple
This rambling post may come across as confusing, which I totally understand. I’ve talked about ATR, and then said I don’t study it. I’ve talked about filtering out low priced stocks, then shown an example of a trade on a low priced stock. But that’s my point. It’s not about setting rigid rules to trade by, it’s about understanding how price affects how we select stocks and how we trade them. Travel range is a concept we need to bear in mind, but only in that we are looking for stocks that are likely to move a decent amount during the session. We don’t need to study historical ATR, we just need to pick good stocks each day. Price is important too, and filtering by price can be a time saver and reduce the potential list of stocks to watch, but it’s only a guideline (there are no rules). We should always consider price when we consider our position size.
The great thing about trading stocks is that there’s something for everyone. Beginners or those with small accounts can choose lower priced stocks. As we gain in experience and as our account balance grows, so do our options. We can look for higher priced stocks to widen our choice, or we can increase our position size on the smaller ones, or we can do both. By considering size — in terms of price and position — we can tailor the market to our own needs, desires, and experience.