One Balancing Technique You Must Learn

In the past, I've written about relative strength between two related stocks or other related markets. I used the SP Stock Index and the Nasdaq Stock Index as examples of this.

What Is Position Equalization and Why Is It So Important To Understand

Let me give you a quick example so you can see why this is very important for you to understand. Let's say you trade stocks and you trade more than one stock at a time. Now let's say for example that you trade two stocks using the same trading strategy. For the sake of simplicity, let's say you trade breakouts and you pick two unrelated stocks to avoid correlation. 

Your first stock is Clorox, the bleach manufacturer, here's what the stock looks like before you enter your order to go long.

Clorox Stock Breaking Out

Notice The Average True Range Filter Below The Chart

In addition to buying Clorox, another stock is also setting up for a breakout pattern and it happens to be from an unrelated software company so there should be minimum correlation. 

You may have heard of this company a few times in the past too. They are the largest personal computer security company in the world.

Symantec Is Also Setting Up For a Breakout To The Upside

One stock sells bleach and the other one sells security products for personal computers, totally unrelated which is great. Now we have to figure out the most important question, how many shares do we buy of each stock.

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How Do You Decide How Many Shares To Buy Of Each Company?

The Average True Range Indicator Will Help You Equalize Your Position

If you don't make your positions equal, your profits and loss from each position will be different and your trading results won't be balanced.

For example, let's say you have 7 winners and 3 losers, if your winners are $1.00 and your losers are $3.00, your trading is not balanced. Your losers and your winners should be very equal in size to each other.

This way, regardless of what market you trade against another market, it will appear dollar wise like you're trading the same markets. When looking at your brokerage equity report, the size of your winners and losers should be approximately even between your entire portfolio.

I know one trader who would bet 100 shares across all stocks but some stocks moved 4 points per day and others moved 2 points per day so his losers and winners were not balanced and there is no way to create a trading strategy when your positions are not equalized to each other.

Just imagine you trade two stocks and the one you bet the least on wins the most, this is not what you want, you want each position to be as equal to your other positions as possible. Here is the easy process that will help you trade any stock swing trading techniques using balanced positions.

The tool that I use to equalize my positions is the ATR indicator. The ATR stands for Average True Range and it's simply a daily calculation of the average trading range of each stock. You can figure this out yourself, but most trading software online and offline have an ATR indicator already build in.

All you have to do is set the Average Range to 10 days, it's usually set at 14 days by default. The ATR indicator will tell you what the average trading range is for each stock that you trade. In our example, Clorox has an average range of .74 cents per day while Symantec has an average daily range of .43 cents. You can easily see that Clorox is almost twice as volatile as Symantec, so trading equal shares wouldn't produce a very even profit to loss ratio between both stocks.

How Do I Equalize These Positions To Each Other

1. Start with figuring out how many shares you want to trade for the most volatile position out of the two stocks. In our case, Clorox is clearly more volatile than Symantec, almost twice as volatile, so we will figure out how many shares of Clorox we want to trade first and then equalize Symantec to that level as well.

To make this simple, let's say we want to trade 100 shares of Clorox stock and you want to know exactly how many shares of Symantec stock will give you the same "bang for your buck" as Clorox stock.

2. Simply divide the larger position by the smaller position and multiply that number by the shares.

In our example the larger positions ATR is .74 and the smaller positions ATR is .43. (You would divide .74/.43 = 1.69) and multiply the result by the amount of shares you chose to trade of the more volatile stock.

3. Since 100 shares were chosen for Clorox stock, you would multiply 1.69 * 100 shares = 169 shares of Symantec stock for every 100 shares of the Clorox Stock.

Don't Underestimate Simple Stock Swing Trading Techniques Such As Position Equalization

Many traders focus so much on being profitable, that they completely ignore the most basic and important principles such as making sure both positions have equal risk and reward profile. Regardless of the stock swing trading techniques you pick, you need to make sure your trading apples to apples and not apples to oranges. Take a look at how both trades would have worked out for you below.

 

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Notice How The Average True Range Changes As The Market Moves Higher And Becomes More Volatile

Symantec Average True Range Also Increasing As The Market Continues To Rally.

As markets rise or fall sharply volatility changes and often increases, this is why it's important to measure the ATR every few days and adjust each of your positions to each other to get equal risk and reward from each position.

Position equalization is one of the most valuable stock swing trading techniques I know of. Next time I will discuss using the ATR to help pick the best stop loss levels to avoid volatility.

 

Roger Scott

Senior Publisher

WealthPress

This article is supplied courtesy of WealthPress.

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