Got Risk?

 

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One More Way that Size Matters

Why is Position Sizing so Important?

Imagine that you had $100,000 to trade. Many traders (or investors, or gamblers) would jump right in and decide to invest a substantial amount of this equity ($25,000 maybe?) in one particular stock because they were told about it by a friend, or because it sounded like a great buy. Perhaps they decide to buy 10,000 shares of a single stock because the price is only $4.00 a share (or $40,000).

They have no pre-planned exit or idea about when they are going to get out of the investment if it happens to go against them and they are subsequently unnecessarily risking a great deal of their initial $100,000.

How Does it Work?

Suppose you have a portfolio of $100,000 and you decide to only risk 1% on a investing idea that you have. You are risking $1,000.

This is the amount RISKED on the investing 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. Keep in mind that you should only invest stocks for which you can spend the adequate amount of time researching. Invest in stocks you know.

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 happens. You should leave that strategy on the gambling tables in Las Vegas where it belongs.

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.

I believe that people who understand position sizing and have a well thought out and executed plan can usually meet their objectives through developing the right position sizing strategy.

Position Sizing—How Much is Enough?

Start small. So many investors who create 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 investors have a much greater chance of losing than they do of winning while they learn the intricacies of investing. It’s best to start small (very small) and minimize the “tuition paid” to learn, create and implement the appropriate strategy. Don’t worry about transactions costs (such as commissions), worry about learning to trade the strategy and follow the process. Once you’ve proven that you can consistently and profitably invest over a meaningful period of time (months, not days), you can begin to ramp up your position sizing strategies.

Manage losing streaks. Make sure that your position sizing algorithm helps you reduce the position size when your account equity is dropping. 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.

Don’t meet time-based profit goals by increasing your position size. All too often, investors 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 with a mindset that values capital preservation.

 

Many people in mainstream Wall Street totally ignore this concept, but I believe that position sizing and psychology count for more than 90% of total performance (or 100% if every aspect of trading is deemed to be psychological).

Position sizing is the part of your investment plan that tells you how many shares or contracts to invest in. Poor position sizing is the reason behind almost every instance of account blowouts. Preservation of capital is the most important concept for those who want to stay in the investing game for the long haul.

In general, your investing capital must be money that you can afford to lose and not funds from which you pay your everyday expenses. In other words, if you lose your entire account, you can still pay your bills.

But more than this, you must manage risk within your account itself. The size of a position that you take on any one investment must never exceed parameters that you set forth. Some traders use hard and fast rules, e.g., “I will never have more than 2% of my portfolio in one position.” Others allow for more flexibility if their strategy indicates a higher probability of success, such as a trend continuation, which allows them to adopt a more aggressive stance at entry and throughout the duration of the investment.

If you are a longer-term investor, holding a security for weeks and months rather than simply days, you may unwittingly create a higher risk for yourself with a trade that is working well. Gains in a position may cause you to unknowingly join the ranks of high-risk over-traders. You may find yourself risking more than you projected at the outset.

Remember, being able to predict the market 99% of the time is useless if you risk all of your equity in every trade. You may start out making a fortune but eventually you will lose it all.

Some further determine their risks by how many positions they hold in any given sector. For example, if you limit your exposure to 2% in any given trade, but you hold 15 positions, all of which are within the energy sector, you have exposed yourself to sector risk.

Risk is also time-sensitive. Some compare the market to being near radioactive material. The longer you are in a position, the more radiation you absorb, and the higher your chances of having an unpleasant result. Therefore, longer trades actually tend to be riskier. Needless to say, if you plan positions to last longer term, you need to familiarize yourself with stop-loss orders to protect your bottom line.

There’s also a risk that your strategy, once profitable, no longer works as well. You must constantly monitor your strategies through utilization of your trading journal and constantly back-checking your trades.