Trader’s Guide 3.2- Position Sizing
How much to Bet
Position sizing is a crucial aspect of trading that is often overlooked by new traders who are focused on finding the perfect entry point or trying to maximize their returns. However, proper position sizing is just as important as finding a good trade, if not more so.
One common misconception among new traders is that position sizing is all about risk tolerance, or how much they are willing to lose on a trade. While risk tolerance is certainly a factor, it is not the only, or even the most important, factor to consider when determining your position size.
The net impact on your account is equally, if not more, important. This means that you need to consider how much a trade will affect your account balance, both in terms of potential profits and potential losses.
There are several ways to position size a trade, each with its own advantages and disadvantages. Here are some of the most common methods:
Fixed fractional position sizing: This method involves allocating a fixed percentage of your account balance to each trade. For example, you might decide to risk 2% of your account on each trade. This approach has the advantage of being simple and easy to implement, but it can be inflexible, as it does not take into account the risk/reward ratio of the trade or the overall market conditions.
Example- Let's say you are considering trading three assets: Stock A, Stock B, and Stock C. You have a $10,000 account balance and you want to risk 2% of your account on each trade.
Using fixed fractional position sizing, you would calculate your position size for each stock by dividing the risk amount (2% of $10,000 = $200) by the entry price of the stock.
For Stock A, let's say the entry price is $50. The position size would be calculated as follows:
Position size = $200 / $50 = 4 shares
For Stock B, let's say the entry price is $100. The position size would be calculated as follows:
Position size = $200 / $100 = 2 shares
For Stock C, let's say the entry price is $25. The position size would be calculated as follows:
Position size = $200 / $25 = 8 shares
As you can see, the position size for each stock is different, because the entry prices are different but each trade has equal risk proportional to the account.
Risk-based position sizing: This method involves calculating the potential risk of a trade and sizing your position accordingly. For example, you might decide to risk no more than $100 on a trade with a 1:2 risk/reward ratio. This approach takes into account the risk/reward ratio of the trade, but it can be time-consuming to calculate and may not be suitable for fast-moving markets.
Example-Let's say you are considering trading three assets: Stock A, Stock B, and Stock C. You have a $10,000 account balance and you want to risk based on the risk/reward ratio on each trade. The stronger the ratio is skewed to the upside the more we will risk.
You have done your research and have determined the following risk/reward ratios for each stock:
Stock A has a risk/reward ratio of 1:3
Stock B has a risk/reward ratio of 1:2
Stock C has a risk/reward ratio of 1:1
For Stock A, the potential loss is $200 (2% of $10,000) and the potential gain is $600 (3 times the potential loss), so the position size would be calculated as follows:
Position size = $600 / $200 = 3 contract
For Stock B, the potential loss is $200 (2% of $10,000) and the potential gain is $400 (2 times the potential loss), so the position size would be calculated as follows:
Position size = $400 / $200 = 2 contract
For Stock C, the potential loss is $200 (2% of $10,000) and the potential gain is $200 (the same as the potential loss), so the position size would be calculated as follows:
Position size = $200 / $200 = 1 contract
As you can see, the position size for each stock is not the same, because you are risking the different percentages of your account on each trade. This theoretically assures the stronger trades will offset the weaker ones for the net portfolio.
Volatility-based position sizing: This method involves taking into account the volatility of the market or the underlying security when determining your position size. For example, you might decide to risk a smaller percentage of your account on a highly volatile stock compared to a less volatile one. This approach can be useful for managing risk, but it can be difficult to accurately gauge volatility, especially in fast-moving markets.
Example- Let's say you are considering trading two stocks, Stock A and Stock B. Stock A has a historical volatility of 30% and Stock B has a historical volatility of 50%. You have a $10,000 account balance and you want to risk 1% of your account on each trade.
Using volatility-based position sizing, you would calculate your position size for each stock by dividing the risk amount (1% of $10,000 = $100) by the historical volatility of the stock.
For Stock A, the position size would be calculated as follows:
Position size = $100 / 30% = 333 shares
For Stock B, the position size would be calculated as follows:
Position size = $100 / 50% = 200 shares
As you can see, the position size for Stock A is larger than the position size for Stock B, because Stock A has a lower volatility than Stock B. This means that you would be taking a larger position in Stock A and a smaller position in Stock B in order to manage risk.
It's important to note that historical volatility is just one factor to consider when using volatility-based position sizing, and you should also take into account current market conditions and the specific characteristics of the stock. This is just one example of how you can use volatility-based position sizing to compare two different assets.
Correlation-based position sizing: This method involves considering the correlations between different assets or markets when determining your position size. For example, if you are trading a portfolio of correlated assets, you might decide to risk a smaller percentage of your account on each individual trade in order to manage overall portfolio risk.
Example- Let's say you are considering trading three assets: Stock A, Stock B, and Stock C. You have a $10,000 account balance and you want to risk 2% of your account on each trade.
You have done your research and have determined that the three stocks have different correlation coefficients to the base portfolio:
Stock A has a correlation coefficient of 0.6
Stock B has a correlation coefficient of 0.8
Stock C has a correlation coefficient of 0.4
Using correlation-based position sizing, you would calculate your position size for each stock by dividing the risk amount (2% of $10,000 = $200) by the correlation coefficient.
For Stock A, the position size would be calculated as follows:
Position size = $200 / 0.6 = 333 shares
For Stock B, the position size would be calculated as follows:
Position size = $200 / 0.8 = 250 shares
For Stock C, the position size would be calculated as follows:
Position size = $200 / 0.4 = 500 shares
As you can see, the position size for each stock is different, because the stocks have different correlation coefficients to the base portfolio and you want to manage overall portfolio risk.
It's important to note that no single position sizing method is perfect, and you may need to use a combination of these approaches in order to find the one that works best for you.
One thing to keep in mind when position sizing is the power of compounding. This means that the effect of a trade on your account balance is not just limited to the potential profit or loss on that trade, but also the potential impact on future trades.
For example, let's say you have an account balance of $10,000 and you decide to risk 5% on a trade, or $500. If the trade is successful and you make a profit of $500, your account balance will be $10,500. However, if the trade is unsuccessful and you lose $500, your account balance will be $9500.
Now let's say you decide to risk the same 5% of your account on the next trade, which is now based on an account balance of $10,500 (in the case of a successful previous trade) or $9500 (in the case of an unsuccessful previous trade). If the second trade is successful, you will make a profit of $525 (5% of $10,500) on this trade. However, if the second trade is successful in the case of the unsuccessful first trade, you will only profit lose $475 (5% of $9500) on this trade. Bringing the total account value for the first loss account to $9,975, Under the original starting capital. This is the compound effect, it is powerful and potent but if position sizing is underrated it can turn winning strategies/investments into losing account balances when strung together.
As you can see, the impact of a trade on your account balance can be compounded over time, especially if you are consistently taking the same percentage of risk on each trade. This is why it's important to carefully consider your position size and not just blindly risk the same percentage of your account on each trade.
Another thing to keep in mind is the importance of finding the right balance between risk and reward. As the famous trader Paul Tudor Jones once said, "Risk management is the most important thing. You have to have a clear idea of how much you are willing to lose on a trade and stick to that.”
It's not enough to just have a good risk tolerance; you also need to have a clear idea of how much potential reward you are seeking in order to determine the appropriate position size. This is where the risk/reward ratio comes into play.
The risk/reward ratio is the ratio of the potential loss to the potential gain on a trade. For example, if you are willing to risk $100 on a trade and you are seeking a potential gain of $200, then the risk/reward ratio is 1:2. In general, the higher the risk/reward ratio, the smaller the position size you should take.
Another factor to consider when position sizing is the confluence of data or the correlation between different assets or markets. For example, if you are trading two correlated assets, such as the S&P 500 and the NASDAQ, you might decide to risk a smaller percentage of your account on one trade in order to manage overall portfolio risk.
It's important to note that position sizing is not a one-size-fits-all approach and you may need to adjust your position size based on the specific trade, market conditions, and your own risk tolerance.
One way to think about position sizing is to compare it to a batter waiting for the perfect pitch to swing at. Just like a batter doesn't want to swing at every pitch, a trader doesn't want to take a trade on every opportunity. A batter waits for the pitch that has the highest probability of success and then takes a powerful swing, just like a trader should wait for the trade with the highest probability of success and then size their position appropriately.
One story that relates to position sizing is that of a trader named John who was just starting out in the markets. John was eager to make a profit and was always on the lookout for the next big trade. However, he was also very risk-averse and was always worried about losing money.
One day, John came across a trade that he was convinced was going to be a winner. The stock was undervalued, the technicals looked good, and there was a lot of positive news about the company. John was so confident in the trade that he decided to risk 50% of his account on it.
Unfortunately, things didn't go as planned and the stock ended up going in the opposite direction of what John had expected. Within a few days, John had lost half of his account balance and was left with just $5,000.
Feeling defeated and frustrated, John decided to take a break from trading to reassess his approach. He realized that he had made a mistake by risking such a large percentage of his account on a single trade, especially one that was not a sure thing.
From then on, John decided to be more mindful of his position sizing and to only risk a small percentage of his account on each trade. By following this approach, he was able to recover his losses and eventually turn a profit.
Proper position sizing is essential for successful trading. It's not just about your risk tolerance, but also about the net impact on your account and the balance between risk and reward. There are several different methods for position sizing, including fixed fractional, risk-based, volatility-based, and correlation-based approaches. It's important to find the approach that works best for you and to adjust your position size based on the specific trade and market conditions.
Remember, just like a batter waiting for the perfect pitch to swing at, a trader should wait for the right trade and then size their position appropriately. By following a careful and disciplined approach to position sizing, you can better manage your risk and increase your chances of success in the markets.
