Position size is one of the most important but often overlooked aspects of trading. It is neglected even by experienced traders. However, beginners and novices meet catastrophic ends just because of overlooking position size.
So, what is position size and why is it important? Do you want to know all secrets, calculators, and best practices rewarding position sizing? Then you are exactly on the platform you need to be. Because we are going to share all you need to know about position sizing. Let’s dive deep and find out.
What is a position size?
Beginners and novices often run into trouble by getting convinced that their setups are perfect. Their trade setups look so solid to them that they begin to think that they would never fail. And this is what sets the stage for the blowing up of their entire trading accounts. So, why does it happen?
It happens because they either don’t know about position size or they overlook it. Yes, you read it right. It is the position sizing that may lead you to huge losses if overlooked. So, what is a position size?
Position size refers to how much money you allocate to a single trade and how it relates to the level of risk you take on that trade. Why does it hurt traders so badly when overlooked? Because taking too much risk on one trade means risking too much. Thus, random position sizing is against risk management and therefore, significantly hurts traders.
Why is position size so important?
Position size is important because it enables you to manage your risk with perfection. Let us try to understand it through an example. Suppose that you have $50,000 in your trading account. You analyze that XYZ stock, currently priced at $10, is doing well and it will go even higher. Now, you plan to buy 3,000 shares of XYZ stock. This was random position sizing. Let’s see now how it will affect you.
Imagine that you eventually bought 3,000 shares of XYZ that cost you $30,000. However, the stock price begins to decline after an earnings announcement. It falls to $9 and continues to decline. Finally, the price settles at $4 within a couple of weeks. Now, you realize that you were wrong and close your position at $15,000. That means you incurred a $15,000 loss and it was just because of random position size. And this is why position size is one of the most important aspects of trading. Traders should never overlook it and they should never decide position size randomly.
What is the best practice for choosing a position size?
There is no hard and fast rule for determining your position size. Firstly, there are multiple personal factors, such as your experience, risk tolerance, size of your trading account, etc., that you need to consider. However, the following two factors can help you determine your position size like a boss.
1. Account risk
Firstly, you need to consider the total available capital. Secondly, you need to decide how much percentage of your capital you can risk for a trade. Again, there is no rule or best practice here. It all depends on your personal traits. For example, most professional traders often choose 1% risk exposure. Whereas, some traders also choose 2% risk exposure.
This is important because it limits your losses. You will lose 10% to 20% of your capital even when you make multiple unsuccessful trades. That said, it is important from the aspect of preserving your capital. However, how much percentage you choose entirely depends on you.
2. Trade risk
The second factor that you need to consider in determining position size is trade risk. It refers to defining your risk exposure per trade in trading terms instead of determining risk exposure in terms of percentage. For example, you buy stocks of a company at $10 and decide to put stop-loss at $9. Your trade risk will be $1 in this case. Trade risk requires you to define stop-loss for your trades after careful analysis of price charts.
Position size strategies
There are numerous position sizing strategies that you can employ to define your position size with ease and perfection.
1. Fixed Dollar Amount
The fixed Dollar Amount strategy, as its name suggests, refers to determining your position size by a fixed dollar amount for each trade. For example, you can decide to risk $1000 on each trade. This strategy enables you to increase the number of positions as your capital grows. Conversely, your number of positions will decrease with decreasing capital.
2. Percentage of Portfolio
Percentage of Portfolio is among the widely used strategies to define position size. It refers to risking a fixed percentage of your portfolio on each trade. The rule here is that you will lower this percentage as your account grows. For example, if you decide to risk 1% of your portfolio, you would lose $100 on your account of $10,000. However, if your account has $100,000, 1% risk exposure means losing $1000 on each trade. Therefore, it is important to decrease this percentage as your account grows.
Furthermore, you can use a very simple formula to define the perfect risk exposure percentage. The formula is;
Position size = Account risk ÷ Trade risk
Where account risk is the maximum amount of your capital you can risk on a trade. Whereas, trade risk refers to the maximum amount you can lose per trade.
The importance of stop-loss in position size
Defining the best entry and exit points before executing a trade is absolutely essential. Stop-losses are imperative in order to minimize risks because they provide you with exit points. They also enable you to quantify your trade risk on each trade. Additionally, they also give you the necessary peace of mind that you have an exit strategy if a trade goes against you. That said, stop-loss placement is always a good idea. But how much importance does stop-loss has in position size? Let’s see.
Whether you choose the Fixed Dollar Amount or Percentage of Portfolio approach, stop-loss plays a vital role. Once you determine the amount you are comfortable risking on each trade, you can easily define your position size by combining that number with where you put stop-loss.
Moreover, there are multiple ways to determine where you need to put stop-loss.
Traders try to combat market noise by putting stop-loss based on multiples of volatility. They use the Average True Range indicator to measure volatility. Once they have market volatility, they place a stop-loss at the multiple of ATR. For example, ATR gives you a reading of 2, then you’ll place stop-loss at 2x. 2x has been the most common multiple for years. However, market noise has increased in recent years according to experts. Therefore, we can increase the multiple to let’s say 2.5x.
2. Standard-deviation based
The standard-deviation based technique involves putting stop-loss at a reference point. The price action on a chart gives you that reference point. For example, you can use a moving average as a reference point. For further confirmation, you can also use the Bollinger Bands indicator to determine standard deviations around the moving average.
3. Vital market levels
You can also use vital market levels to define your stop-loss. Vital market levels include support, resistance, or indicator values. However, this technique also requires you to consider market noise before placing a stop-loss.
4. Percentage loss in price
Percentage loss in price is the most simple technique to define stop-loss. It involves selling your instrument if its price decreases by X%. Although this technique is simple and also looks inferior to other techniques, it still is an effective one.
Position size is one of the most important aspects of trading. It is so important that it may prove vital in your overall trading journey. You can achieve success by considering it. Conversely, you may lose a lot of money by overlooking it. Why so? Because it is your position size that helps you to manage risk with perfection. Although it isn’t that much fun to talk about position size, it is important. Perhaps, most traders lose money just because they don’t prefer to talk about trading aspects that aren’t that much fun. However, you need to give position size the importance if you want to maximize your gains while limiting risks.