Position sizing is one of the most important elements for success when trading stocks. Even so, many traders usually neglect this strategy and give very little coverage compared to entry and exit strategies.
To control risk and get the most of out of your money, it is important to understand what position sizing as well as the various techniques of determining the ideal position size when trading shares, contracts or whatever other financial instruments you are trading.
Position Sizing Explained
Position sizing is a strategy that consists of adjusting the number or size of shares of a position before or after initiating a buy or a short trading order. If applied correctly, this strategy can dramatically help a day trader to avoid ruin and maximize returns. It answers the question; how many contracts or shares should I buy?
There are several techniques that traders can apply to determine proper position size when day trading stocks. Let us now briefly look into each technique.
Fixed Risk Per Trade
This position sizing technique consists of three variables that are used to control the amount that a trader risks per trade. The variables are: risk per trade, maximum risk, and stop loss.
Risk per trade is the percentage of the trading capital a trader wants to invest for each single position, while maximum risk is the percentage of the capital that he/she will invest. Stop loss refers to the maximum loss the trader has allowed for each trade.
Decide the percentage amount of your account balance you are willing to risk on a single trade. Most professional traders usually risk 1% or less of their total capital on a single trade. If you choose 1% and lose on a trade, you have only lost 1% of your capital and 99% is still intact.
Although some traders tend to risk up to 2% when using a proven system, it is advisable to stick to 1% on each trade especially if you are starting out because a string of losses could significantly hurt your account. For example, on a $10,000 trading account, don’t risk more than $10 (1% of account) on a trade. Above all, use a stop loss to control your risk.
The Kelly criterion position sizing technique was developed by a scientist called John Kelly. It is based on the concepts of win/loss ratio (the percentage of winners among all trades) and the winner probability (odds of a given trade to offer a positive return).
The Kelly criterion will tell a trader the maximum percentage that he/she should invest in any single stock, depending on the performance of past trades. It may tell you to invest all your money in three stocks or tell you to invest in more than 10 highly diversified stocks.
Fixed Dollar Model
When using this basic money management method, the number of positions in your portfolio decrease as your portfolio equity decreases and increase as the portfolio equity increases.
If you want to risk $500 per trade and your portfolio equity is equal to $10,000, then the simulator will take about 20 positions. When your portfolio equity decreases to $5,000, your portfolio will have about 10 positions.
Volatility-Based Position Sizing
In this method, each new stock to buy or short is analyzed based on its historical volatility and then the number of shares to trade is determined by the volatility of the stock.
If the historical volatility of a given stock is high, the trader should ought to reduce the number of shares that he/she wants to buy since the risk involved is also higher. In other words, traders who use this strategy anchor their position sizes to the volatility of the stock markets.
Managing the position size of your trades is the key to managing risk. Position sizing helps you determine the amount of your portfolio equity you are ready to risk with each trade. Newbies tend to concentrate on the outcome of a trade, ignoring the tools to manage risks and the anatomy of the risks. Since the outcome of a trade is not certain, it is important to determine a proper position size in your trades to avoid risking too much or too little.