Stock Market Position Sizing
Stock market position sizing (sometimes rather imprecisely called money or account management) is the ‘how much’ of trading. The position sizing formula (also called the position sizing algorithm, but let’s stick with the easy word) tells you how much you can buy or hold for each trade (an open trade is called a ‘position’). The purpose is to limit (as far as possible) your exposure to each open position to an amount you are comfortable with.
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The position sizing formula can be stated as:
V=R/S where V = Volume R = Amount to risk S = Stop loss amount |
Percent risk
The first step is to calculate R, the amount to risk on this position. This is normally expressed as a percentage of your equity (your trading capital) and is really a function of your risk tolerance. The mistake beginning investors usually make is to set this percentage way too high. So if you plan to risk 25% of your capital on each trade, realize that it will only take 3 or 4 losing trades in a row to reduce your capital to a size that is too small to trade. The first rule of trading should be ‘preserve precious capital’, and you should be able to clearly see why from this table:
The first step is to calculate R, the amount to risk on this position. This is normally expressed as a percentage of your equity (your trading capital) and is really a function of your risk tolerance. The mistake beginning investors usually make is to set this percentage way too high. So if you plan to risk 25% of your capital on each trade, realize that it will only take 3 or 4 losing trades in a row to reduce your capital to a size that is too small to trade. The first rule of trading should be ‘preserve precious capital’, and you should be able to clearly see why from this table:
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Drawdown (Loss)
10% 20% 50% 75% 90% |
Gain needed to recover
11.1% 25% 100% 300% 900% |
So a 50% loss of capital needs a 100% gain to recover – a major mountain to climb. As a beginning investor, your goal should be to stay in the game while you learn, so you should be very conservative with your capital at risk. Most sources agree the figure should be somewhere between 0.5% and 2%. Let’s say for this example we have a trading equity (our capital) of $50,000, and are willing to risk 2% on each trade, i.e. $1,000. If the idea of losing this amount brings you out in beads of sweat, this might be a clue that 2% would be too high for you!
A common misconception when we're beginning investing is to believe that the amount we are risking on each position is the amount we paid – so if we buy 10,000 stocks of Company X at $1 each we would be risking $10,000. However, the only way we could lose $10,000 is if the value of X went to zero before we could get out. This can of course happen, but it's extremely unlikely. Even in the most drastic of circumstances (think investment banks during the subprime crisis) we usually see a stock lose value over days or weeks, giving us many chances to sell and retain some value. To calculate the expected amount at risk we would need two figures:
· the price we intend to pay for the stock; and
· the price at which we'll conclude that the trade isn't working, and close the position (this is known as the stop loss).
In our example we intend to buy Company X at $1.00, but have determined that we'll exit the trade if the price falls to $0.95 (we'll talk more about how the stop loss might be determined in another article), so we're only risking $0.05 per share.
We now have all the information we need to calculate V, the volume. Plugging the figures into the position sizing formula we get:
V=$1,000/$0.05
So we'd buy 20,000 stocks at $1.00 each. If the price fell to $0.95 we would sell, for a loss of 20,000 x $0.05 = $1,000.
The more you play with the position sizing formula, the more you'll understand what a powerful tool it is in meeting your trading objectives. You'll discover that your Win Rate (ratio of winning trades to losing trades) is negatively correlated to your Average Profit per Trade. You want more winners? Then give yourself wider stops, but realize that you'll be able to buy fewer stocks. Are you happy with a succession of small winners, or do you want to swing for the fences? It’s all in the position sizing formula.
· the price we intend to pay for the stock; and
· the price at which we'll conclude that the trade isn't working, and close the position (this is known as the stop loss).
In our example we intend to buy Company X at $1.00, but have determined that we'll exit the trade if the price falls to $0.95 (we'll talk more about how the stop loss might be determined in another article), so we're only risking $0.05 per share.
We now have all the information we need to calculate V, the volume. Plugging the figures into the position sizing formula we get:
V=$1,000/$0.05
So we'd buy 20,000 stocks at $1.00 each. If the price fell to $0.95 we would sell, for a loss of 20,000 x $0.05 = $1,000.
The more you play with the position sizing formula, the more you'll understand what a powerful tool it is in meeting your trading objectives. You'll discover that your Win Rate (ratio of winning trades to losing trades) is negatively correlated to your Average Profit per Trade. You want more winners? Then give yourself wider stops, but realize that you'll be able to buy fewer stocks. Are you happy with a succession of small winners, or do you want to swing for the fences? It’s all in the position sizing formula.
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A Trader's Money Management System
Bennett A. McDowell Risk control tends to be the last thing that most traders focus on, perhaps because of the popular belief that it's their trading strategy that will generate great fortunes. But ultimately, a strategy alone won't create riches. A trader or investor needs to develop discipline, a strong financial psychology, and a sound money management system to maximize profits and keep them out of financial danger. In A Trader's Money Management System, veteran trader Bennett McDowell offers readers an expert guide to the most important elements of money management in trading. |