Position Sizing - The Most Important Aspect of Money Management
Reduce Your Risk of Ruin.
Minimizing losses is much more important than maximizing profits.
The size of your position is arguably one of the most critical elements of your success as a trader. While the trading strategy you use is essential to finding profitable opportunities, sound capital management techniques are just as crucial to longevity as a trader.
As a rule, capital preservation is one of the biggest challenges for new traders. And your position size has everything to do with that.
An appropriate size is often the difference between long-term success and short-term failure.
Most traders over-trade their account and this is one of the biggest single causes of the 90% plus trader failure rate. Despite appropriate sizing of your position being fundamental to trading, many traders just trade one standard or 'mini' contract or what they 'feel' is right.
Definition of Position Sizing
Position sizing is the dollar value being invested into a particular security by an investor. An investor's account size and
risk tolerance should be taken into account when determining appropriate position sizing.
The position size basically refers to the size of a position within a particular portfolio, or the dollar amount that an investor is going to trade.
The Successful Trading Strategy
The pyramid indicates the most important aspects to an overall successful trading strategy.
The majority of traders place more importance on trade entry when the real key to success lies within the three facets of psychology, money management and size of their position.
Trading Risk Capital Only!
You should be trading risk capital only. That means money you’re able to lose without losing sleep. In other words, don’t transfer the mortgage payment or your 401K into your brokerage account to make a trade.
Trading essentially comes down to an odds game -- even in a trading system that generates statistically significant positive returns, bad luck can still hurt any individual trade. That’s the number-one reason why you should only use risk capital to trade. Sound money management lets you survive the bad luck and profit in the long run.
Psychology is another factor. Knowing that a losing trade means foreclosure or no food on the table adds a psychological burden that can only cloud your trading judgment.
When you are using a position size consistent with your preferred level of risk - your fear level drops, your error rate falls away, you start noticing fresh aspects of the market behavior and your trader behavior that previously your fear had hidden from you. This leads to improvements in your trading system, a higher reward to risk ratio and more profits. To get to this virtuous circle of more confidence, less fear, more improvements, calmer, more improvements, calmer, more improvements, calmer, you need to derive an appropriate sizing of your position.
There isn’t a set in stone rule for the size of your position. A lot of personal factors like the size of your account, your risk tolerance, and your experience, all need to be considered when deciding on how big of a bet you should make on each transaction. That said, "risk of ruin" -- that is, the chance that you’ll blow up your account if you hit a “cold streak” -- decreases dramatically as your risk approaches 2% or less of your portfolio.
However, as already stated, there are no binding rules – only those that you set yourself. Here’s a general rule of thumb:
• Limit your investment in any particular stock to 4% of your equity portfolio’s net worth.
• If you want to err on the side of caution, invest less. If your tendency is toward being aggressive, invest more. But not too much more.
• You should also consider the type of stock you’re investing in. For example, you might feel more comfortable having a larger weight in a blue-chip stock.
Amount of Risk Capital to be used on each Trade
The amount of risk capital referred to here is risk -- or money on the line -- not total size. So for a $10,000 account, for example, a trade with a 5% stop loss level would justify a $4,000 position at a maximum. You shouldn’t stand to lose more than 2% of your total account value on any given trade.
Higher risk trades mean that you should be taking smaller positions. On the flip side, incredibly low risk trades allow more experienced traders to use leverage safely.
The best rule of thumb is to stay within your comfort zone. On that $10,000 account, if a $1,000 or $500 position size is the most you’re comfortable with, follow your gut and ramp up to 2% as you gain experience.
Adapting the Size of Your Position to Volatility
When market volatility increases, traders often reduce the size of their position to compensate for the additional risk. This technique automatically ties position size to volatility.
Higher volatility means greater risk, and it can wreak havoc on trading strategies that don’t adapt. As the markets go through extremes stages of volatility, traders invariably increase both their stops and profit targets. But such adjustments are meaningless without addressing the size of your position. Therefore, it is advisable to reduce position size during these periods of higher volatility, which will help mitigate this increased risk. Here is one way to automatically adjust position size to market volatility by combining two risk-control methods:
• fixed-fractional position sizing and
• volatility-based stops.
Definition of Fixed-fractional Position Sizing
Fixed-fractional sizing consists of risking a specific percentage of account equity on each trade. After you determine this percentage (e.g., 2 percent), multiply it by your current account equity and then divide by the trade risk, which is defined as the per-share (or per-contract) dollar amount you would lose on the next trade if it is exited with a loss. The equation is:
Position sizeff = ff*Equity
ff = fixed fractional percentage
Equity = current account equity
TradeRisk = the dollar loss per contract of the next losing trade.
For example: assume you are risking 2 percent of your account equity on each trade and you plan to buy the E-Mini S&P 400 MidCap futures (EMD) at 775 on March 19 with a stop-loss at 773.
Because each point (1.00) in this market is worth $100, your trade risk is $200 per contract; if your account equity is $25,000, you will buy two contracts on the next trade because:- 0.02*25,000/200 = 2.5 (the number of contracts is rounded down to the nearest contract).
If the market drops to 773, you will lose $400, approximately 2 percent of equity.
Consider the following to prevent “ruination”:
• reduce the size of your position until you know what it should be,
• understand the risk of ruin concept,
• determine what you mean by ruin,
• decide your acceptable risk of ruin,
• determine your risk of ruin at your current size of your position,
• set the size of your position such that your risk of ruin is acceptable,
• trade profitably with good feelings.
Remember that the stock market, historically speaking, favors the investor. (Conversely, horse-racing is rigged in the house’s favor. The track skims enough off the top of each race so that it always wins.) Watching size of your position will ensure that you’re around long enough to reap the rewards.
As a trader, it’s tempting to focus on your trading strategy and nothing else. But that’s a major mistake. Make a concerted effort to preserve your capital, and you’ll stand a much better chance of finding trading success for the long haul.
Position sizing could very well be the most important aspect of a trading system, yet, like expectancy, it’s rarely covered in trading books. A position sizing model simply tells you ‘how much’ or ‘how big’ of a position to take. The size of your position can be the key factor in whether or not you stay in the game or whether your gains are huge or minimal.