Beware the Dangers of Oversizing - TheStreet

I'll bet you've lost more money in 2009 due to overtrading and oversizing than to poor stock selection. In the real world, limiting the total number of trades and keeping down your position size yields greater annual returns than throwing darts at the dartboard every time you think you see a fantastic opportunity.

While overtrading can undermine the most carefully planned market strategy, oversizing is even more dangerous, because it has the power to wipe out a trading account in a very short time. What exactly is oversizing? Simply stated, this perilous activity marks the tendency to enter positions that are too big, too risky or beyond the skills of the average trader.

Oversizing destroys equity by triggering catastrophic losses that cannot be overcome. The problem starts with a misconception that you need to trade large size in order to make money or to compete with the market's "big boys." As it turns out, nothing could be further from the truth, because small size lets you survive sudden reversals and still achieve the reward visualized in the pattern or setup being traded.

Big size equals big risk, and that means you have to be right

in a hurry

when you carry large positions. This simple fact is ignored in the rush to get into a hot play you've uncovered in your analysis or heard about in a chat room. It goes something like this. You want into a trade and calculate how much margin can be squeezed into the position. Regrettably, you never consider how much money you'll lose if you're wrong. Like the fool on the hill, you jump in heavy and blind with no awareness of the danger.

Traders need to manage position sizing through three variables that affect the reward-to-risk ratio. Each of these elements requires a sizing strategy that minimizes risk and maximizes reward.

    Choose how many total shares to hold or sell short.

    Choose to assume the risk of the position all at once, or in pieces.

    Choose to unwind the position all at once, or in pieces.

    Get control by ignoring margin when working through the details of your intended entry. The best place to start this calculation is on the loss side. Take a deep breath and determine exactly how much you would lose at different size levels if the position goes bad. Then, take a position that matches your risk tolerance, and not a penny more. Although this sounds simple, traders exceed this magic number all the time because of that destroyer of wealth known as greed.

    It's absolutely vital that you think small if you have a small trading account. To be truthful, you won't turn that $10,000 stake into a million bucks in this lifetime, so stop trying. Instead, scale down your position size and hit for singles, rather than swinging for the fences. Yes, you can still make a lot of money, but you'll need to increase your holding period to weeks or months, rather than minutes or hours.

    Well-capitalized traders who have established track records can take big size when the market offers low hanging fruit. As a general rule, these seasoned folk should trade big for short time periods and trade small for long time periods. Just keep in mind that courage is inversely proportional to position size. In other words, large positions can play with your head and induce panic attacks, while small positions will give you the tenacity to stay in the trade until its profitable conclusion.

    Always align size with the market you're trading. To state the obvious, there's a big difference between 1,000 shares of a sleepy food processor and 1,000 shares of a low-float Chinese nanotech play. Drop down to even smaller size when trading issues that have average trading of under 200,000 shares per day. This prophylactic approach will keep you from getting hurt too badly if a panic hits or if hedge funds start to run the stops.

    Broadcom

    (BRCM)

    shows how different sizing strategies can yield different outcomes. The stock rallied back to the July 2008 swing high at $30 last September and dropped into a consolidation pattern. Price has pushed through the top of this range and looks ready to move substantially higher. The next rally could fill a 2007 gap between $35 and $41.

    The stock is ticking higher in a rising wedge, with support near $31.50. This pattern exposes the trend to a downswing that carves out a rising channel. A buyer of 2,000 shares at $32.50 might incur a $5,000 drawdown if that happens, even though the decline wouldn't hurt the technicals. Many retail traders could never recover that lost capital.

    Alan Farley provides daily stock picks and commentary with his "Daily Swing Trade" newsletter.

    Meanwhile, a holder of just 300 shares would get hit with a $750 drawdown, which is far more "survivable" in most retail accounts. A subsequent recovery might then yield a healthy $2,500 profit, while it frees up considerable cash for other opportunities that might come along while Broadcom grinds toward the reward target.

    At the time of publication, Farley had no positions in stocks mentioned, although holdings can change at any time.

    Alan Farley is a private trader and publisher of

    Hard Right Edge

    , a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of

    The Daily Swing Trade

    , a premium product from TheStreet.com that outlines his charts and analysis. Farley has also been featured in

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    . He has written two books:

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    , due out in April. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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