START – Position Sizing
Position sizing strategies tell you how much throughout the course of the trade
Their purpose is to help you meet your objectives whether that is:
- To maximize your chances of receiving X%
- To minimize your chances of having a drawdown as big as Y%
- Or some combination of both
- There are as many objectives as there are traders
Simple Position Sizing Strategy
Remember that your system is a distribution of R-multiples with a mean value equal to its expectancy. Position sizing strategies allow you to equate R across trades. Thus, through position sizing methods, you can make 1R equivalent to 1% of your portfolio through what I call CPR for traders
• R = risk per unit
• C = cash or total risk per position
• P = position size or how much
Formula: P=C/R
Position size = cash/risk per unit
Who are you?
• A risk manager whose job is slow appreciation with minimal risk?
• A speculator who wants maximum profits if at all possible no matter the consequences?
• A speculator who wants outstanding returns with minimum risk
What are your objectives?
• To attempt to achieve some objective such as make 100% in a year
• To avoid some particular drawdown amount that you might consider ruin at all costs
• To attempt to achieve your objectives while making sure you don’t have a particular drawdown
What’s your position sizing strategy
• Risk a little more after each loss (eventually, a win will come). This is a recipe for disaster but it is still a position sizing strategy
• Risk a constant amount such as $100
• Risk a percentage of your equity
• Risk a percentage of your equity or a bigger percentage of your winnings
So How Does Position Sizing 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 ends in success. 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 by developing the right position sizing strategy.
Position Sizing — How Much is Enough?
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 Is Better To Start Small
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 modify your position sizing strategy to help you take advantage of times when you should either increase or decrease position size. But before you begin to incorporate a strategy with variable position sizing, you should first learn to be thoroughly comfortable with a consistent approach to position sizing. Determining and maintaining a consistent position size is the best way to minimize the effect of the biggest challenge to trading profits that all traders face: a losing streak.
Manage Losing Streaks
Once you have a consistent approach to position sizing, it will be useful for you to identify likely losing streaks that your system may generate. All systems generate a losing streak now and then and your position sizing algorithm can help you reduce the position size when your account equity is dropping during a losing streak. 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.
Determining a Losing Streak
One simple way to anticipate the impact of a potential losing streak is to simply understand the statistical probability of your system’s outcome. For example, if your system generates a winning trade about 50% of the time, then you can expect, statistically speaking, to model losing streaks with the probability of a coin flip.
Most people comprehend that flipping heads 8 times in a row is a rare event. One which has less than a 1% chance of occurring. However, what if you were given 200 chances for that event to occur? What would be the probability of getting an 8-in a row losing streak in that circumstance? The answer is roughly about 33%. All of sudden this event doesn’t seem so rare! In fact, consider the following information on streaks in the following table:
Based on this data you can see that it might make sense to use a position-size rule that reduces risk in the event that you have seven losers in a row. Anything more than seven in a row would be an outlier event, and one you would want to protect yourself against. Using the same data, you can see that you would need to plan on experiencing a seven in a row losing streak over the course of 200 trades.
Think of the power of a position-sizing strategy for managing your trading through such a losing streak! If you knew you were going to have a seven-in-a-row losing streak, and you also knew you didn’t want to have much more than a 10 percent drawdown in your trading, then you would realize that you needed to risk less than 1.4 percent of your account on each trade (10 percent drawdown divided by 7 is about 1.4%). By executing this position sizing strategy, and reducing your position size for every loss past seven in a row, you can minimize the impact of a losing streak. That’s trading like a Pro Trader!
Warning:
Strongly resist the urge to 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!
