When it comes to how to invest and The IBD Methodology, we talk a lot about position sizing. There are various ways to determine an initial position size, based on your conviction in a given stock and the overall market. Once you have that, you can add to your position as the stock passes new bullish entries or pulls back.
One method of determining position size is by limiting any full position to 10% to 12.5% of your overall portfolio. This way, you limit the total number of stocks in your portfolio to eight to 10. Depending on how much conviction you have in a given stock, you may choose to start your position at a full size, which would be 10% of the portfolio, a half size (or 5%) or a quarter position of 2.5%.
But what if 2.5% still feels too big? What if underlying market conditions are so unstable, or the stock you're looking at feels too risky to invest even 2.5% of your portfolio?
In this situation, you'll want to use what's known as a pilot position.
How To Invest With Pilot Positions
Pilot positions allow you to gauge market feedback and invest incrementally. They allow you to test the waters a little at a time to see if a stock is working or not, without sizable risk on the line. Instead of a 2.5% (or quarter) position, you might start a pilot position by risking just 1% of your portfolio.
There are three reasons why you might want to do a pilot position instead of a normal position.
First, when you're in a market environment that's riskier, a pilot position can help you manage risk. When the stock market's in a clear uptrend, it makes sense to be aggressive with your buying. But in a bad market, you may be better off with a smaller position to test the water. If your stock heads south amid market weakness, the low exposure lets you bail out without much damage.
Second, when you have a more volatile stock, pilot positions can be a good idea to avoid getting whipsawed.
Third, you might use a pilot position when you're taking on a stock that's a bit extended or still in a chart pattern. Before you put the full position to work, you'd start with a pilot position with the idea that if it starts working and the market is giving you positive feedback, then you'll add to the position.
Building Out Your Position
Once you've initiated the position and it starts to work in your favor, it's time to build out the position. But this gets a little tricky.
Normally, when we're building a position, we use a pyramiding style: You start with half the shares you plan to buy, then each subsequent buy is a little smaller. That makes it so the average cost of the position doesn't go up too much.
Say your ultimate goal is to have a 10% position of a stock in your portfolio. Your first buy would be half of that 10% goal. Then you'd add another 30% of your planned position after the stock tops a follow-on entry. After that, you'd add the remaining 20% once the stock makes more progress.
If you're starting with a much smaller position, the risk is that you don't get enough money into the position fast enough if the stock starts climbing right away. Also, it could increase your average cost.
When you start with a smaller position size, you must be ready to quickly increase the position.
