Asset Allocation is a fancy phrase that encompasses the whole area of who,what,when, where, and why of stock investing.
One of the most frequently asked questions in the MorningHoursTrading chat room is this: "How much equity should I use on each trade?" The short answer: it depends. The long answer is the reason for this two-part article.
Let me preface my remarks by saying that I am not a financial advisor. Financial advisers can assist you in determining asset allocation decisions based on your individual circumstances. But, then again, most financial advisers would warn you against day trading to start with, so...there you go.
There are eight considerations when deciding the "how much equity to use on each trade?" part of asset allocation. We'll cover the first four in this article. There is a link at the bottom of the page to see the remainder of the article. And I'll get at each point by starting each one with a question.
1. How does the equity on this trade compare with your total available equity? In other words, your answer depends on how much capital you have available. If you have $200,000, then trading the entire amount on a single trade would seem (to most people) to be a high risk trade. You would be "putting all your eggs into one basket" as they say, and therefore your risks are higher. So, at a higher level of equity, more diversification is both possible and recommended. On the other hand, if you have $10,000, then you might want to put half of your equity into one trade - assuming, of course, that you know how to make a profit by trading stocks. That would give you $5000 for one trade, and a 1% profit would still give you $50 - adequate for profit minus trading fees.
2. What is your average percentage gain per trade? Many traders don't know the answer to this one. But here's the reason for asking it. If you only make half a percent profit on average, then an investment of $2000 will barely cover your brokerage fees. On the other hand, if you are new to trading and you are still losing money, then it is better to trade smaller amounts until you get things figured out. So, go back to your records and figure out your average gain per trade. While you're there, take a look at your "per day gain" - this helps you compare your day trading gains with your swing trading gains and helps you discover your strengths. Just take your percentage gain on each trade and divide it by the number of days you held the trade. That will give you the answer and help you as answer the question of asset allocation.
3. What amount do you have allocated for various trading activities? Some of this depends on how much equity you have available for trading. But, one of the ways you can achieve diversification is by dividing your equity into piles. For example, if your analysis from my second point reveals that you are a better swing trader than day trader, then you might want to allocate 60% of your equity to swing trading, 20% to options, and 20% to day trading - even if you enjoy day trading more. This also assumes, of course, that you have sufficient capital to create such diversification. If you have $10,000 to invest, then your choices are more limited.
4. How comfortable are you with higher amounts of equity? Becoming a profitable trader takes time. You don't just open up an account and suddenly figure out how to do this stuff. You have to study, practice, and stick with it long enough to become good at it. It's not much different from anything else. But one of the ways to gauge your answer to the initial question is by simply doing a gut check. You know, ask yourself if you feel too nervous when you begin to use higher amounts of equity. You may have had some big losses that cause your palms to sweat when you start using more than $20,000 on a single day trade. That's fine. You're not ready for that yet, so don't push it. Come back to a level where you feel comfortable. Then, if your profit per trade improves, start raising the amount of capital you're using per trade. But don't try to progress too fast. Listen to yourself. If you're feeling nervous, then drop back a notch. The nervousness could cause you to make poor trading decisions because your fear of loss is too great.
So, those are your first four considerations. Hopefully this will get you started in answering your question regarding asset allocation. The other four points are covered in Part II of this article.
Click here to read Part II of Asset Allocation for Day Trading.