What to Know About Proper Position Sizing when Trading
Position sizing is subjective -- what may be right for one trader might be too much for another. But you should have some risk management in place, so I put together this very quick guide on proper position sizing.
It occurred to me that most traders take a random position size when trading. In fact, most beginning traders have no clue what I’m talking about because they just pile money into each trade, one at a time and wait to see what happens.
Really it’s like betting all on black in Las Vegas – either you make it big or you don’t. Those are not the odds I want.
Set A Firm Stop Loss Level
There must be a place on the charts where you call it quits. This is the area where the charts via technical analysis tell you that it was a bad trade and you were wrong. Remember, we are all going to have losses; it’s the traders that learn from them that prosper.
To determine position sizing you must first set a firm stop level. As a rule of thumb, a trader should not risk more than 1-3% on a single trade. Less is better, but don’t put your stop too close so that any minor movement in the market will hit it quickly. Larger accounts are likely to risk much less than 1% of capital on many trades.
Be Consistent With Your Positions
If you really want to develop a great system you need to be consistent with position sizing. For example, if you are risking 4% of your money per trade, always risk 4% unless you change your rules. There is no trade out there that is SO great that it requires more money than your max risk per trade – period.
Let’s face it. It’s so easy to get tempted to increase a position size when trying to meet time-based profits. For example, if you promised yourself that you would make a certain profit after a given period and failed to achieve it, it’s easy to find yourself thinking, “I need to double (or triple, or worse) my position size to help me hit my goal.” Many have incurred massive losses after taking this destructive route. So, be safe and just stick to your original position sizing plan to the end.
Let’s look at two examples:
$10,000 Account Position Sizing
As a simple example for educational purposes, let’s assume you have $10,000 to trade with. You have decided that you can have a maximum loss of $200 if you risk 2% of your capital on each trade. Doesn’t sound like much money, but if you cannot manage $10,000 effectively, how are you going to manage $100,000 one day?
To determine how many options contracts to buy we take our 2% investment of $200 and divide it by the price of the call/put. If the call/put is trading for $20 each, then we are going to buy 10 contracts.
Once we have our position sizing figured out, we have our stop set on each trade at a 2% max loss. If it’s hit then we are done and get out – bad trade, move on, and forget about it. If the position starts to turn a profit, however, then consider moving up your stop loss to lock in the profit. Simple right?!
$100,000 Account Position Sizing
Things change when you have more money. However, experience has taught me that this is the time to be even more risk adverse and protective over your portfolio. Believe me. I lost $10,000+ the very first week I traded at home. I thought I was a big shot and didn’t have a plan laid out and paid big time for this valuable experience.
If you have a $100,000 account let’s assume that you only want to risk 1%, or $1,000 per trade. Larger accounts should, of course, be risking less per trade unless you are a crazy day-trading cowboy.
But the same method above is applied to this larger account. You take your max risk per trade and divide it buy the number of contracts you want to buy. Using the same price as above, if the call/put is trading for $20 then we would need to buy more than 50 contracts.
Larger accounts that trade this many contracts tend to benefit from cheaper commissions and better use of account margin requirements. Still, you need to make sure that you are properly addressing your risk tolerance level. Have a system and work the system!
How To Determine Your Most Appropriate Position Size
As I mentioned earlier, it’s important that you stick to risking a maximum of 1-3% on any single trade. However, if you are a seasoned investor, then it could be worthwhile to try out various position sizes depending on the particular investment you want to make.
For example, if you are buying a safe, cheap dividend stock, it wouldn’t be suicidal to risk up to 5% of your account on it. On the other hand, when dealing with traditionally volatile vehicles such as junior resource stocks or options, then smaller position sizes of even half of 1 percent of an account would be more suitable.
Unfortunately, a majority of novices do not have time for such evaluations and thus end up risking three, five, or even 10 times as much as they should. What happens in such a case is that one finds a stock, option trade, or commodity they're really excited about. They then begin fantasizing about all the profits he or she could make by investing in that particular trade. Without even giving it a second thought, they go ahead and make a huge bet. Instead of placing a more sensible bet of $400, for example, this trader ends up impulsively buying shares worth $2000. Needless to say, doing so would amount to a disaster if a company or commodity suffers a big, unforeseen move. What is even worse is the fact that recovering that money could take them quite a long time and perhaps even discourage them from trading ever again.