How many shares or contracts should you take per trade? It’s a critical question, one that most traders don’t really know how to answer properly.
Position sizing™ strategies are the parts of your trading system that answers this question. They tell you “how much” for each and every trade. Whatever your objectives happen to be, your position sizing™ strategy achieves them. Poor position sizing strategies are the reason behind almost every instance of account blowouts.
Position sizing is the part of your trading system that tells you “how much.”
Once a trader has established the discipline to keep their stop loss on every trade, without question the most important area of trading is position sizing. Most people in mainstream Wall Street totally ignore this concept, but I believe that position sizing and psychology count for more than 90% of total performance (or 100% if every aspect of trading is deemed to be psychological).
Position sizing is the part of your trading system that tells you how many shares or contracts to take per trade. Poor position sizing is the reason behind almost every instance of account blowouts. Preservation of capital is the most important concept for those who want to stay in the trading game for the long haul.
Why is Position Sizing So Important?
Imagine that you had $100,000 to trade. Many traders (or investors, or gamblers) would just jump right in and decide to invest a substantial amount of this equity ($25,000 maybe?) on one particular stock because they were told about it by a friend, or because it sounded like a great buy. Perhaps they decide to buy 10,000 shares of a single stock because the price is only $4.00 a share (or $40,000).
They have no pre-planned exit or idea about when they are going to get out of the trade if it happens to go against them and they are subsequently risking a LOT of their initial $100,000 unnecessarily.
To prove this point, we’ve done many simulated games in which everyone gets the same trades. At the end of the simulation, 100 different people will have 100 different final equities, with the exception of those who go bankrupt. And after 50 trades, we’ve seen final equities that range from bankrupt to $13 million—yet everyone started with $100,000, and they all got the same trades.
Position sizing and individual psychology were the only two factors involved—which shows just how important position sizing really is.
How Does it Work?
Suppose you have a portfolio of $100,000 and you decide to only risk 1% on a trading idea that you have. You are risking $1,000.
This is the amount RISKED on the trading idea (trade) and should not be confused with the amount that you actually INVESTED in the trading idea (trade).
So that’s your limit. You decide to RISK only $1,000 on any given idea (trade). You can risk more as your portfolio gets bigger, but you only risk 1% of your total portfolio on any one idea.
Now suppose you decide to buy a stock that was priced at $23.00 per share and you place a protective stop at 25% away, which means that if the price drops to $17.25, you are out of the trade. Your risk per share in dollar terms is $5.75. Since your risk is $5.75, you divide this value into your 1% allocation ($1,000) and find that you are able to purchase 173 shares, rounded down to the nearest share.
Work it out for yourself so you understand that if you get stopped out of this stock (i.e., the stock drops 25%), you will only lose $1,000, or 1% of your portfolio. No one likes to lose, but if you didn’t have the stop and the stock dropped to $10.00 per share, your capital would begin to vanish quickly.
Another thing to notice is that you will be purchasing about $4,000 worth of stock. Again, work it out for yourself. Multiply 173 shares by the purchase price of $23.00 per share and you’ll get $3,979. Add commissions and that number ends up being about $4,000.
Thus, you are purchasing $4,000 worth of stock, but you are only risking $1,000, or 1% of your portfolio.
And since you are using 4% of your portfolio to buy the stock ($4,000), you can buy a total of 25 stocks without using any borrowing power or margin, as the stockbrokers call it.
This may not sound as “sexy” as putting a substantial amount of money in one stock that “takes off,” but that strategy is a recipe for disaster and rarely happens. You should leave it on the gambling tables in Las Vegas where it belongs.
Protecting your initial capital by employing effective position sizing strategies is vital if you want to trade and stay in the markets over the long term.
People who understand position sizing and have a reasonably good system can usually meet their objectives through developing the right position sizing strategy.
Position Sizing—How Much is Enough?
Start small. So many traders who trade a new strategy start by immediately risking the full amount. The most frequent reason given is that they don’t want to “miss out” on that big trade or long winning streak that could be just around the corner. The problem is that most traders have a much greater chance of losing than they do of winning while they learn the intricacies of trading the new strategy. It’s best to start small (very small) and minimize the “tuition paid” to learn the new strategy. Don’t worry about transactions costs (such as commissions), just worry about learning to trade the strategy and follow the process. Once you’ve proven that you can consistently and profitably trade the strategy over a meaningful period of time (months, not days), you can begin to ramp up your position sizing strategies.
Here’s what our friend and colleague D.R. Barton said about it: “I’ve talked to many folks who have blown up their accounts. I don’t think I’ve heard one person say that he or she took small loss after small loss until the account went down to zero. Without fail, the story of the blown-up account involved inappropriately large position sizes or huge price moves, and sometimes a combination of the two.”
Manage losing streaks. Make sure that your position sizing algorithm helps you reduce the position size when your account equity is dropping. You need to have objective and systematic ways of avoiding the “gambler’s fallacy.” The gambler’s fallacy can be paraphrased like this: after a losing streak, the next bet has a better chance of being a winner. If that’s your belief, you’ll be tempted to increase your position size when you shouldn’t.
Don’t meet time-based profit goals by increasing your position size. All too often, traders approach the end of the month or the end of the quarter and say, “I promised myself that I would make “X” dollars by the end of this period. The only way I can make my goal is to double (or triple, or worse) my position size. This thought process has led to many huge losses. Stick to your position sizing plan!
This information will help guide you toward a mindset that values capital preservation. This article comes from my Tharp’s Concepts material and though many have read it before, it is information that bears repeating…and no better time than with the release of the new Definitive Guide to Position Sizing Strategies, Second Edition!