Stock Trading Mathematics that you SHOULD Know-For Beginner and Novice Traders
Contrary to popular belief that stock trading is complex and unpredictable that it needs sophisticated mathematical tools; this is not entirely true. Mathematics for stock trading should be as simple as possible using no more than algebra! These mathematical tools are very important during the stock selection process, money management and managing your trades. Bookmark, share this article and link to this tutorial so that other beginning traders will know. If something is missing in those formulas, feel free to contact me and I will add that. Let’s start summarizing what are these important mathematical principles that you need to know:
1.) Computing the total amount of investment required:
Total investment = Price per share X Total number of Shares
This is really simple. If the price per share is $10 and you would like to buy 100 shares. So the total investment required (excluding commission):
Total investment = $10 x 100 = $1000
2.) PEG Ratio – valuing the stocks whether it is good or not.
PEG Ratio – (P/E ratio)/(Growth Rate)
It is simply equal to P/E ratio divided by the growth rate. Growth rate is equal to:
Growth rate = (Earnings per share(current) – Earnings per share(one year ago))/Earnings per year(one year ago)
Illustration: Compute the PEG ratio of a stock with P/E ratio of 25 and the following earnings per share data:
Earnings per share (current) = $1.4
Earnings per share(one year ago)=$1.25
Growth rate = ($1.4-$1.25)/($1.25) = 12%
PEG Ratio= 25/12 = 2.08
The rule is to invest stocks with a PEG closer to 1.0 or even lower. In the above example, since its 2.08, its not a good stock.
3.) PEG Ratio for companies that paid dividend
PEG Ratio adjusted= (Growth rate + Dividend Yield)/(PE Ratio)
Illustration: Compute the PEG ratio adjusted for the following stock:
Growth rate= 12%
Dividend yield= 1.5%
PE ratio= 25
PEG Ratio adjusted = (12+ 1.5)/(25)= 0.54
A good rule is to select stocks that have PEG Ratio adjusted greater than 2. The example has value at 0.54 which is way below 2, so its not a good stock. There are less chances the stocks can be profitable.
4.) Estimated profit – based on a clear support and resistance data assuming you buy at support and sell at resistance.
Estimated profit = [(Price per share at resistance level) – (Price per share at support)] x Number of shares bought
5.) Stop Loss Price – the price that you will automatically sell the stock to prevent further losses.
Stop Loss price = Entry price – %Stop Loss x Entry Price
If you enter the trade at $15 which is the stock price and you decide to implement 10% stop loss order to your broker then (assuming you go long not short):
Stop Loss price = $15 – 10% x $15 = $13.5
If you expect the price to go up but instead it went down; your order will exit at $13.5 to prevent further loss.
6.) Expectancy – the average profit per trade.
Expectancy = (Winning percentage * Average dollars per win) – (Loss percentage * Average dollars per loss ) – Commission per trade
Illustration: Supposing you have an automated trading system that produces the following statistics:
Number of trades made= 110
Number of wins =40
Number of losses= 70
Total profits from winning trades = $10500
Total losses from losing trades = $2100
Commission per trade = $5
The winning and losing percentage is:
%Win= 40/110= 36.36%
%Loss= 100%=36.36%=63.64%
The average dollars per win:
Average dollars per win= Total profits from winning trades/Total winning trades = $10500/40=$262.5
Average dollars per loss = Total losses/Total losing trades = $2100/70 =$30
Finally expectancy:
Expectancy= (36.36% x $262.5) – (63.64% x $30)- $5 = $95.445 – $19.092 – $5 = $71.353
It means that on every trade, the net profit is $71.353 including trading commissions.
7.) Double your original investment – the rate of return or interest required to double the original investment
%annual return required= 72/years
Supposing you invest $30,000 in stocks and you would want to double it after 5 years. The required annual % return is:
%annual return required = 72/5 =14.4%
Thus you need to have your portfolio return a rate of 14.4% annually so that in 5 years, the worth of your investment doubled.
8.) Kelly Criterion – this will enable you to compute the optimal %risk that will maximize the return of your investment This is not for conservative traders.
You can read this tutorial on Kelly Criterion Investing: Calculator and Strategy.
9. ) Maximum drawdown – maximum number of consecutive losses in trading. This is important since string of successive losses can be emotionally hard to accept.
You can read this tutorial on the computation of maximum drawdown in trading.
Related posts:
- What is a High PE ratio? Is it a good or bad investment?
- Kelly Criterion Investing: Calculator and Strategy
- Trading Expectancy and Risk to Reward Ratio Trading System analysis
- Stock Trading 101 : Basic Definitions
- Calculating Stop loss price using Risk & Reward|Support and Resistance