What Everybody Ought to Know About Proper Position Size When Trading

position size

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I was coaching a long time student last night and 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…

Position sizing when trading is of course subjective. What can be good for one trader could be bad for another. But you still need to have something in place and so I decided to put together this very quick guide.

Share your own personal position sizing rules, thoughts, etc. in the comments to let other traders see what you are doing.

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 then you have to be consistent with position sizing. For example, if you are risking 4% of your money per trade then 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 we risk 2% of our capital on each trade. Doesn’t sound like much money but if you cannot manage $5,000 effectively, how are you going to manage $500,000 one day?

To determine how many option 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 only buy 10 contracts.

Once we have our position sizing all 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 was trading 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. Therefore it was much quicker to lose money.

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!

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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 percent 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 percent 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 he’s really excited about. He then begins fantasizing about all the profits he or she could make by investing in that particular trade. Without even giving it a second thought, he goes ahead and makes a huge bet. Instead of placing a more sensible bet of $400, for example, this trader ends up buying impulsively 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 especially if the loss was catastrophic.

How Do You Size Your Positions?

Whether we risk a percentage of our account on each trade, or choose a fixed dollar amount we all do it differently. Don’t be bashful in sharing your own personal view on position sizes, stop loss, and allocation in the comments section. You can also ask for help and suggestions on position sizing for a particular trade or account you have.

Instead of learning these lessons the hard way (i.e. losing your shirt in the market), why not take my free 4-part video course as I cover each area in detail. Plus, I’ll go over the exact checklist I use for selecting trades each month!

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he’s a Full-time Options Trader and Real Estate Investor.

He’s been interviewed on dozens of investing websites/podcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.

  • I use the % risk model. Some thoughts here http://ripetrade.blogspot.com/2011/03/position-sizing.html

    • Kirk

      @Ripe Trade, Yeah that’s another way of doing it — thanks for sharing.

  • WadeB

    I agree, the risk model is the way to go for tend following. For options I would rather do some sort of gamma scalping if I think it’s worth buying and selling the stock. I’d be interested to see if any one else here does gamma scalping?

  • Hey Kirk – important post..well argued and of course essential case for position sizing made. Couple of differences in mechanics with options trading that i would suggest – firstly lets assume we are using the price chart of the underlying as you identify above..if doing so as a minimun you would use delta surely to work out a potential loss in option value and subsequently deduce the numbers of contracts from that..happy to have a chat if you are interested in sharing some ideas mike@horizonprofessional.com.au

    Have a awesome week ahead mate..and thanks again for the post

    Mike

  • Pushkar

    I trade in near the month options and so get a lesser amount of time value, also am a NET seller in otm options.As the premium amount is very less so in that case how to place a STOP LOSS?

    • Kirk

      @Pushkar, Great question. It really depends. Most traders who sell OTM options use some sort of percentage based rule for their stop loss (like 100% – if the option increases in value by 100% then they are out). I’m personally not a fan of this because you can have a volatility move in the option and yet it might still be a great trade based on time until expiration and distance from the underlying…I would rather use some sort of probability based stop loss.

      • Pushkar

        @Kirk,
        Thanks kirk,
        But I found out that even the box strategy dosent work in Indian markets.In this case what kind of strategy would you suggest to do in Indian markets? Also tell me when the position goes agaisnt our trade how to hedge it ??

      • Kirk

        @Pushkar, When the position goes against your trade you can either close it out with a stop loss or look to use some sort of option protection.

      • Pushkar

        @Pushkar,
        If i am short on ABC 100 ce@2 and the rate goes to 4 and still the position is OTM and Cmp is 98 but days for expiry is 10, in this case what is the protective strategy I should apply ?

  • Alan Adams

    I trade options. I prefer to risk .5% of my entire portfolio, I heard numbers anywhere from 5% down to one-half of one percent. I could not stomach anything higher the .5%. I can sleep better at night and I find this level easier to defend

  • Jasmeena

    Hi Kirk, do u include brokerage in the risk that u calculated?

    • Kirk

      @Jasmeena, If you mean commissions, no since it can be widely different depending on your account balance, broker, etc. Thanks for the question!

      • Jasmeena

        @Kirk, yeah i mean commissions. and these commissions change the equation. Thanks for the reply.

  • Yes you can be at 2% that’s fine. I think in your case the debit spreads aren’t the best trades to be risking a lot of money generally.

  • We publish a detailed “When to Exit” guide inside our membership dashboard with all the specifics for each strategy.

    • Arnab Sinha

      Are you referring to the free module – “Entries & Exits”? If not can you please provide a link to the module you are referring?

      • Noe – check the “PDF Guides & Checklists” page or search for it.

      • Arnab Sinha

        Thank you I found it. I reviewed the PDF. Since I am only playing spreads, it’s recommended to exit when the trade has attained 50% of max profit. Right?

      • Correct

      • Arnab Sinha

        Kirk, I had a question about rolling spreads. If originally I traded 2 contracts which equates to 2% of my account value. When I roll a trade to recover my initial loss, to what extent of exposure should I limit myself. Should it be at most 5% account value or should I always roll the same # of contracts I started with?
        What should I keep in mind when doing rolls?

      • Good question. IMHO I think rolling is just a form of “adjusting” and therefore you should not increase your position size.

  • Yep when you go bigger in portfolio and account size it just means scaling into bigger option contracts and underlying like SPY, RUT, etc.