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Price Leverage vs. Risk
By Jason Mitchell
Price leverage is often misunderstood for representing a good risk reward opportunity. The truth
is while price leverage can lead us to greater percentage movements, the risk reward ratios often favour
medium priced stocks.
What Is Price Leverage ?
When we talk about price leverage we are talking about the ability of a low price to make
large % moves compared to higher priced stocks. This is usually one of the first things anyone
buying stocks tends to realise. I remember at about the age of ten, discussing with my
Dad how he should buy lower priced shares because it meant that he could buy more shares.
I knew from the milk bar I could buy more 2 cent lollies than 10 cent lollies! I did not
understand the concept of percentages, but I could see that if two shares went up by 2c,
the stock he owned more of would give him more money. If I could see it way back then, I
would imagine every one picks up on it.
The premise behind the theory really is not so much about the number of shares owned, but the
peoples perceptions to the change in price. If I want to buy a stock that trades for $10.00 and
suddenly it goes to $11.00 a $1.00 difference is a pretty big thing in my mind. If I am looking
at a 20c share and it goes to 22c, the 2c does not seem as big a move. Of course they are both
10% rises.
How does this affect things, well in times of heavy buying or selling the prices tend
to move up or down quickly as each new buyer or seller is happy to take 1 or 2 cents difference to
get in or out. A 1 cent rise on a 20 cent share is 5%. If a 20c share goes up by 5c which seems like
nothing it would be a 25% increase. To get the same increase on the $10.00 share it would have to get
to $12.50.
It is well known that the majority of the stock markets biggest movers in % terms are the smaller price
shares. It should be noted that price leverage works both ways however. What goes up quickly due to
price leverage can also come down quickly.
Does Price Leverage Provide the Best Opportunities for Gain?
NO
I believe price leverage is a valid phenomenon. Despite this I do not always
believe that price leverage is always the best option in terms of risk reward ratios.
While I agree that a 10c share is often able to increase by 20% in a shorter space of
time than maybe a $5.00 share, the position size that can be taken on some of these low
price shares actually negates the effect of price leverage.
For example, let’s look at two shares. The first one is $0.30 and has a stop at 2c lower at $0.28.
The other is at $4.00 and has a stop 15c lower at $3.85. If your maximum risk is say $500.00 then the
position sizes that are allowable are:
The first share allows 23005 shares at a cost of $6921.45 – putting at risk 500. Share 2 allows a
position size of 2934 at a cost of $11,765.95, this puts $500.00 at risk. If both shares go up by ten
percent then the gains are: (note difference in brokerage due to change in position value, 2nd share
greater than $10,000).
10% Rise 15% Rise 20% Rise 25% Rise
Share 1: $650.25 $995.00 $1,340.00 $1685.48
Share 2: $1,113.70 $1700.50 $2,287.30 $2874.10
These figures show us two things. The first is that the smaller price share has to rise by almost 20%
to give us the same return as the bigger share rising by 10%. The second thing I note is that the
second share had to rise by almost 25% to improve the risk reward ratio to 3:1. The larger price
share had reached this level with a growth of about 14%. Had both shares gone up 25% the larger
price share would have offered a risk reward ratio of almost 6:1 while the lower price share was
just over 3:1.
The key to risk reward ratios simply lies in taking your maximum allowable position, while keeping the
risk level below acceptable limits. Should a share not allow a maximum position or very close to, then
leave it. I would never take a position that does not allow me to take a position size of at least 80%
of my maximum.
For example if I had a maximum allowable position size of $10,000 and a maximum risk level of $500 then
I would only buy a share that allowed me to take a position of greater than $8000. This does not mean I
have to take the whole $8000 dollar position. I can scale it back from here, as the risk level will also
be scaled back as I reduce the number of shares. The following table demonstrates my point. Notice how
in the second line I have altered the number of shares to buy. This reduces both the total cost and the
risk. This leaves the risk reward ratio in tact.
This Article is written by Jason Mitchell
© Copyright Jason Mitchell 2006