Whether day trading, swing trading or investing, position sizing is one of the most crucial elements for success. Unfortunately, it is usually neglected and gets very little coverage when compared to trade entry/exit methods. There are two common types of position management; one predominantly used by longer-term traders, and the other which short-term traders should adhere to. To effectively trade, control risk and get the most "bang for your buck" out of your trades, it's important to understand how position sizing works and the best methods for accomplishing the ideal position size.
What Is Position Sizing?
Position sizing is how many shares you take when trading a stock or ETF, or how many contracts you buy when making a futures trade.
Many traders just “wing it,” buying as much as their account will allow, or buying a large position if they feel very confident in the trade, or a small position if they aren’t as confident.
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These are not effective methods for determining an ideal position size.
Why Is Position Sizing So Important?
For active traders, and even investors who want to avoid the major drawdowns in their accounts that inevitably occur during crashes, position size must be of paramount importance.
Without proper position sizing, it is possible that you could lose a substantial amount of capital on a single trade.
Assume for a moment you have $50,000 with which you trade. You feel confident that stock XYZA, currently priced at $10, is going higher. You decide to buy 3000 shares, costing $30,000. Earnings come out the following week and the stock drops to $9, and proceeds to decline over the following week, finally settling at $5. You admit you were wrong and close out the position, for a loss of $15,000 in a matter of weeks, nearly a third of your trading account.
There are two major problems here. The position size, 3000 shares, is random and not calibrated to the account size. Risk was also not controlled in any way when the trade was placed. Defining how much we are willing to lose is something every trader should do on every trade.
Equal Dollar Strategy Explained
The equal dollar position sizing strategy is when a specific amount of capital is allocated to each trade. The dollar amount is determined by the trader based on account size and how diversified they wish to be.
Assume a $100,000 investment account. The investor decides they will only take up to $5,000 in any stock trade they make. The investor can therefore buy 20 stocks, investing $5,000 in each.
A more conservative investor, wishing to be more diversified, may buy 40 stocks, only investing $2,500 in each.
Given this scenario, assume our investor wants to invest $2,500 in Braskem S.A. (BAK). The current share price is $12.43. Divide the desired investment amount by the share price to get the position size: $2,500 / $12.43 = 201 shares. Since most shares trade in even 100 shares lots, the investor buys 200 shares, getting very close to the $2,500 investment goal.
All charts courtesy of StockCharts.com
A not-so-conservative investor may decide to invest $20,000 in each stock, and only take five positions. For such a non-diversified portfolio, a stop loss strategy is recommended, as discussed below, on each of these trades.
The equal dollar method is mostly used by passive investors, because it is an easy and efficient way to allocate capital.
With this method it is best to invest a small portion of the total account in each stock, achieving some level of diversification. That way, if some stocks go down, hopefully some of the others will rise, offsetting the loss.
A stop loss can also be utilized with this method to control risk within each trade. When buying $2,500 worth of stock, the trader may not wish to risk all that capital should the company fail. A stop loss can therefore be placed below the entry price to close out of the position if a loss becomes too large.
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If an investor has a lot of positions they may choose to simply close out a position if the stock declines by 15%. Therefore, a stop loss order is placed 15% below the entry price. If the stock declines 15%, the trade is closed out and the trader preserves 85% of the capital allocated to that stock. Using the chart above, if the stock was purchased at $12.43, a stop loss is placed 15% below, at the $10.57 level.
The stop loss percentage used in this example, which could be called an equal stop loss if applied to all positions, is also typically used by longer-term traders because it eliminates the need to place a stop loss order that is specific to the stock.
A specific stop loss could also be placed on each trade, as shown in the next section, which utilizes the equal dollar method.
Equal Risk Strategy Explained
The equal risk position sizing strategy is typically used by shorter-term traders because it requires the use of a stop loss tailored to the stock.
With this strategy, the trader can use all their capital and take a short-term trade in one stock, but the stop loss prevents them from losing more than a specific percentage of their account. Equal risk also means equal percentage risk. Many traders only risk 1% of their account on any one trade.
Assume Trader Joe has an $80,000 trading account (assume no leverage) and only risks 1% of his account on each trade. This means Joe can risk $800 per trade.
He buys Ford (F) stock at $17.09 and places a stop loss just below the recent low at $16.70. The risk is $0.38 per share (difference between entry price and stop loss price). To figure out how many shares he can take, to make sure he doesn’t loss more than 1% ($800) of his account, he divides the amount he can lose by the risk per share: $800 / $0.38 = 2,105 shares. Round this down to 2,100 shares.
With the equal risk method it doesn’t matter how much of the capital is allocated to the trade – $35,889 of $80,000 in this case. The focus is on the stop loss, and calculating the ideal position size based on how much we wish to risk (percentage of our account).
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This method is much more fine-tuned to the individual stock. A trader can put all of their capital into one stock with this method because the risk is controlled to a small portion of the account.
The Bottom Line
Long-term investors will likely find the equal dollar method of position sizing easiest to implement. By investing a small portion of the total account capital in each stock some level of diversification is achieved. Stop losses can be implemented on each position to control risk, either by using a fixed percentage risk or by applying individual stops to each position.
Short-term term traders typically use the equal risk — also called equal percentage risk — position sizing strategy. This is because diversification doesn’t matter as much to short-term traders. The trader wishes to utilize their capital on opportunities, but keep risk controlled to a small percentage of their account while doing it. This method requires placing a stop loss and then calculating the position based on the individual risk of the trade.
Both methods can be utilized by any trader, as can any stop loss strategy. The ultimate goal is to make sure that no single trade creates a large drawdown in the account; this is accomplished by making sure the position size matches the goals of the trader for controlling risk.