Asset allocation is an umbrella term that covers many different areas of stock investing. As I mentioned in Part I, the question of "How much equity should I place on each trade?" is just one of many questions related to this. Part I covered the first four of eight considerations. This article will cover the last four points. I approach each point by asking a question. Click here to read Part I of Asset Allocation for Day Trading.
5. What is your level of trading skill and experience? Notice I didn't just ask about years of experience. Some traders have been beating their heads against the wall for years without making much profit. So, skill is part of my question. One of the ways you can measure skill is by analyzing your profitability. I mentioned this in the first article, but it bears repeating here. Figure our your per trade profit or loss. Regardless of how much you might enjoy day trading, do not increase your equity per trade stake until you have learned how to be profitable. I know this may sound simplistic. But, some traders try to make up in volume what they lack in skill. They trade with too much equity and they trade too often, before they have learned how to trade skillfully. This is putting the cart before the horse, as they say, and it is a quick road to losing all of your equity.
6. What are your psychological tendencies as a trader? I'll ask some more questions to help you understand what I'm asking you here. Are you a gambler by nature, enjoying the adrenalin rush of high risk trading? Do you panic when your trade shows a negative number? Does that panic cause you to get out of the trade too quickly or hang on too long? Here's my suggestion. Until you get a better handle on the emotional maturity required to be a day trader, then I suggest you use smaller amounts of equity per trade. I'm not trying to offend you here. But, it is a fact that some people treat the stock market like an online casino. For others, fear is their main emotional relationship with money, and therefore they panic because they also lack a strategy for trading. In either case, smaller amounts of equity would be advised until more emotional maturity is gained. And this can only be gained by having more experience. So, part of the answer to asset allocation is determined by your levels of skill and experience. Being honest here will help you avoid unnecessary risk.
7. What is the price per share of the stock you are trading? One approach to the "equity per trade" question is to use the same amount of equity per trade. So, if you have an account with $100,000 in it, then you might trade $10,000 per trade. But another approach is to use a bracket approach. For example, you might allocate differently based on the price of the stock. To use an obvious example, you probably shouldn't buy $10,000 of a stock that cost less than $1 per share and also buy $10,000 of a stock that cost $200 per share. So, you might use $2000 equity for stocks under $5, $5000 for stocks between $5 and $20, etc. These are just examples. You have to decide these things for yourself. I'm just trying to help you think through your asset allocation strategy.
8. What is your risk allocation on this trade? Again, let me explain what I mean. If you are using some sort of strategy for trading stocks that is based on technical indicators, then there are times when you feel very confident about your decisions and times when the indicators are not speaking quite so clearly. So, you can choose to never play those riskier trades. Or you can use less equity on those trades. I call this risk allocation. It means that you use less equity on the riskier trades and more equity on the trades in which you feel complete confidence, based on your levels of skill and experience.
So there you have it, eight questions for asset allocation - or, more specifically, deciding how much equity to place on each trade. As I said in the beginning, "it depends". Now you have a larger explanation of what those words mean to you. My suggestion is that you go back to the beginning of each point I've made in this two-part article. Take the time for some honest reflection and actually write down your answers to the eight questions regarding asset allocation. Your answers may change over time as you build your account and as you become more experienced. So, date your answers. Stick the paper in your portfolio binder. Then review it from time to time.
Here's an article from the SEC regarding asset allocation: click here to read the article.