Position Sizing

Position Sizing is a common term used to describe the process of deciding the size of your trade, in other words, sizing your position.

Position sizing is one of the important parts of money management, yet it is quite a simple concept to grasp. As a side note, depending on what type of product you trade, your position sizing model will be different.

Whatever you do with your position sizing, the important thing to remember is to not place all of your money into one trade – this would be crazy!

Remember the primary aim of trading … preserve your capital. Do everything you can to take care of it.

“Don’t focus on making money; focus on protecting what you have.”
Paul Tudor Jones

So placing a lot of your money into one trade is crazy! Make sure you break up your capital into small pieces and spread your risk across a number of trades / positions.

The easiest way to position size is to break your trading capital into equal pieces. For example, if you had a trading capital of $20000, you could easily break up your capital into 5 x $4000 pieces

or 4 x $5000 pieces, or 8 x $2500 pieces or any other reasonable combination. By spreading your money across different positions, you are eliminating the possibility that the large and sudden fall in the price of an individual stock can affect your whole capital and trading activities.

I believe the most effective method to determine the number of shares to purchase is to divide your risk amount by the amount of cents you are prepared to let the share price move against you before you would exit at a loss. Click here if you need to read up about the risk amount.

Let’s look at some examples, with the following conditions:

Initial Conditions

Trading capital: $20,000
Maximum limit per position: 20 per cent or $4,000
Risk amount: 2 per cent or $400

Example 1: (Technical Stop Loss)

Let’s say you consider purchasing XYZ, which is currently trading at $1.25. You have decided to place your initial stop just below its previous support level, 12¢ away.

Position Size (number of shares)
= Risk amount / Distance to stop
= $400 / $0.12

Now include the current share price
= 3,333 shares x $1.25
= $ 4,166.25

Note, this amount is more than your maximum limit of $4,000. Therefore, you would only commit $4,000 to this position (i.e. 3,200 shares). This simple position sizing model has concluded that the level of risk in this position is tolerable and you can commit your maximum limit of $4,000.

The theory and key behind the above model is that, if the share price moves down to your exit level, you will only lose your risk amount and nothing more, because you have managed the number of shares purchased.

Example 2: (Volatility Stop Loss)

As another example, let’s say you consider purchasing XYZ, which is currently trading at $1.25. XYZ’s ATR(15) = $0.068 and you are using a 2ATR stop (i.e. you will exit if the security moves two average days against you).

Position Size (number of shares)
= Risk amount / 2 x ATR
= $400 / $0.136

Now include the current share price
= 2,941 shares x $1.25
= $ 3,676.25

Note that this amount is less than the maximum limit of $4,000. Therefore, you would only commit $3,676 to this position. This simple volatility-based position sizing model is restricting the number of shares purchased due to the increased risk.

If there were less risk perceived by a smaller ATR, the model would permit you to purchase more shares. However, always remember your maximum limit; in this example 20 per cent of trading capital.

Many traders misinterpret the rules of probability. Some believe that, if you have an unprofitable trade, then somehow this increases the chance that their next trade will be profitable. If they incur a string of losses, then their chance of a profitable trade also increases as each unprofitable trade passes.

That is clearly not the case, as each trade is completely independent of any other. Disregarding this, many people increase their position size after a loss or string of losses in an attempt to regain their losses quickly. Rather, this is a time when you should be even more diligent to ensure that you scale back your positions and not increase them.

If you think of the laws of probability, increasing your position size after a series of losses in order to breakeven faster is a recipe for disaster.

Having an effective position-sizing model is essential and, in my opinion, is the most important part of risk management.