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Position SizingShould you place 100% of your capital in one trade? How about 50% or just 20%? It is an awkward question to most new traders. One has to be forgiving towards their ignorance, if they are yet to discover “position sizing” as a powerful money management tool. Most traders are wrong more than 50% of the time. And that's fine. - Vic Sperandeo, a Dallas-based options trader Yet, successful traders make money from less than 50% winning trades. Why? Because they “cut losses short and let profits run”. They follow an ironclad stop-loss rule to limit losses. They do not allow any losing trade to go more than, say, 7% below the purchase cost. But they hold the winning trades and sell, say, on an average 35% gain. Hence, thanks to the disciplined approach of cutting losses short and letting profits run, they make more money offsetting the losses. Money management becomes even more critical for options and futures traders, because derivatives exhibit far greater price volatility than equities. Besides, unlike equity traders, they also face unique time constraints. Equity traders don't have to exit a trade under time constraint. As a result, they tend to be much more focused on entering a trade than worrying about how to get out of it at some point of time.
If you are limiting your risk to 2% (of total capital) it would take 50 consecutive losing trades to wipe out the total capital – a rather improbable scenario. But, it is equally important to be aware that often there will be series of losses in a row, called drawdown. This knowledge is an important ingredient of a good trader’s mindset. Risk control becomes most important during the drawdown periods even if you have a wonderful trading system. How is position sizing done?
Your total trading capital is $100,000 and you want to buy a stock, ABC, at $50 a share. You want to limit your trade risk to no more than 2% of the total capital. Based on volatility of the stock, you have decided to exit at $40 if things turn unfavorable; hence you place a stop loss sell order at $40. 2% of $100,000 is $2,000; Another Example: Now assume that you want to buy another stock, XYZ, also at $50 that is rather less volatile and you decide to put the stop order at $45. 2% of $100,000 is $2,000; Your account size will change as you take trades. When it has grown, you will be able to take bigger trades, and vice versa. Consider the following examples: Account size: $95,000 Account size: $95,000 Note that the trade size critically depends upon where you decide to place your stop. It is always better to allow stock volatility and market conditions to govern the stop-loss location. It may be prudent to be more conservative in the beginning when you are learning and setting up your trading system, so you might want to limit your risk to, say, just 1% of total trading capital giving you smaller trade sizes. When a trade moves in your favor and you lock in profits with a new trailing stop, your risk on this profitable trade is nil. You are now free to initiate another trade which is again 2% of the slightly larger account size due to the profits of last trade. Trading this way with discipline, you are always in control of your risks. Advantages of position sizingThe biggest advantage of position sizing is that it improves profits during winning streaks and curtails losses during losing streaks. During winning streaks, your capital grows leading to slightly larger position sizes. And during losing streaks, the position size shrinks, leading to smaller losses. Most traders instinctively do just the exact opposite. They take bigger positions after losing trades only to suffer bigger losses. And when they win, they shrink the trade sizes, restricting profits. This is often described as gambler's fallacy – an intuitive tendency to raise bets during losing streaks and lower bets during winning streaks. Position sizing is the key factor that prevents you from blowing-up your account or risking too much on any one trade. It decides how long you stay in the trading game or whether your gains are large or limited. Position sizing is the bridge between risk management (which concerns – where do I place my initial stop) and money management (which concerns – how much money should I put in a trade). By learning prudent ways to decide on stop order placement which factors in market condition and stock volatility, you would have more realistic trade positions, which in turn, should impact positively your expectancy (win/loss ratio). |
Money management should begin even before you enter a trade – it starts with position sizing. It means consciously deciding on the quantum of loss that you are prepared to take in any single trade. It is normally fixed as a percentage of the total trading capital. Most successful traders rarely risk more than 2% of total trade capital in a single trade; professionals limit themselves to 1% or even less.
In the most basic sense, a trader can divide his capital into smaller lots and trade each lot separately. Even if he enters a trade that goes bad and he loses completely, his maximum loss will be limited to the size of the lot -- he can never lose his entire capital in a single trade. However, an intelligent trader can follow a systematic approach, as presented here, to calculate his trade size along with stop loss order and keep his risk under control. In order to calculate the position size, two parameters are required: (1) the percentage risk of the total trading capital on a single trade, and (2) knowledge of your 