Posted on

Trading – The importance of Position Sizing in your trading system: Part 1

Mon 14 Jan 2019

If there is any factor which can single-handedly give a trader the biggest benefit of being very successful in the long run, it is arguably the subject of position sizing.

In a two-part series, we look at why position sizing is so important to the survival of a trader and why optimum position sizing can beat even stocks selection in certain market conditions.

We also look at why probably 95% of common traders foolishly ignore the mechanics of position sizing at the cost of their likely failure in the market almost every time.

Position sizing is the part of your trading system that you use to meet your objectives with the appropriate risk safeguards.

One can have the best trading system or stock pick (for example a system that makes gains 90% of the time and in which the average winner is say twice the size of the average loser) but the fact is that you still could lose all your trading money if you risked 100% on one of the losing trades.

This is a position sizing problem. The purpose of a good trading system is to make sure that you can still achieve your trading objectives easily through position sizing.

Even if all traders were to enter into the same trades, their size of success in the long run may well differs on only one variable and that is how much they risked (i.e. their position sizing).

It was quoted that an academic study had said that 91% of the performance variation of 82 retirement portfolios was due to position sizing.

Most institutional funds may buy the same trades as markets tend to move on herd mentality (trade selections by analysts are crowded) and one of the variables of performance then is how much one player elects to risk on each trade (beside the entry and exit price).

Several factors will determine your own appropriate position sizing as an elite trader and this will differ on your own trading system objectives, your psychology of trading and the method of position sizing that you can use to protect your portfolio.

For example, if your trading objective is to recklessly make a 100% return on just one or two stock positions in the fastest time, you would have risked your entire capital on just a few stocks and find your capital decimated if the calls were wrong for whatever reasons.

Secondly, if your trading psychology is to trade aggressively all the time looking for the biggest wins and throwing caution to the winds, your style of trading would be that you would not mind going bankrupt for the sake of betting on a few so-called “jackpot” trades.

As we all know, these are common disaster stories by common traders and a sure way to the poorhouse when things turn wrong.

The third is your position sizing method. While there are many methods that you can use, the methods are not cast in stone and the most important criteria is to ensure that you do not risk too much of your equity at any point in time on any stock positions regardless of how confident you are on the trade.

Typically, as an elite retail trader, you should not risk more than 5%-10% of your capital (equity) on any one trade.

The reasons why most are not willing to do this boil down to the lack of selections they have (likely because they don’t have a trading system) and the work involved to track a higher number of open positions.

The risk in each trade will differ from one trader to another and the type of trader’s risk-appetite and the size of his fund and liquidity available in the trade.

For example, an aggressive trader may risk 10% of his portfolio on a single trade with ample liquidity and fundamental safeguards. An institutional fund may only risk 3%-5% on the same trade while a large pension fund may risk only 1% on the same trade.

The percent risk method above is only one of the position sizing methods you can use in your trading system and is highlighted here because it’s easy to understand and use for most traders.

However, it may not be the most optimum method.

There are many different position sizing models and many different varieties of each model built to suit different trading systems.

Here are some other methods where you could base the position sizing of your trading system on:

1). Based on a fixed unit of money for each contract trade. For example, you choose to risk only a $200 loss for each stock that you buy. The amount can be adjusted for each class of stocks like penny stocks, small cap stocks, institutional big cap stocks, etc.

2). Based on the volatility of the stock. You can risk a percent of your equity based on the volatility of the underlying asset rather than a fixed % risk.

3). Based on the asset class in your portfolio using a tactical asset allocation and apportioning risk per such asset class in the portfolio. Or a position sizing based on overweighting/underweighting of stocks in sectors in the portfolio at different market conditions/economic cycles.

4). Based on the long and short positions in the entire portfolio. Such hedging of the portfolio could see the allocation of risk based on market conditions to the entire portfolio risk based on the total long and short positions of the portfolio.

5.) Limiting the loss of equity in each trade to a certain amount such as a stop loss threshold of say 20% of each trade in the portfolio regardless of its position size in the portfolio.

6) Multiple tiers position sizing. For example, one may risk 5% of the stock equity in the portfolio at lower price (say when buying undervalued stocks) and when the stock price reaches a certain profit (higher level), one will risk only a lower percentage say at 3% at that time.

7) Adding in and out of positions when certain criteria are met for a stock or the whole stock portfolio such as based on alpha or beta probability calculations at different times.

8) Based on periodic reallocation to a set of non-correlated stocks or factors

Whichever method you choose, you can always optimize your position sizing to meet your trading system objectives.

At the first step, you must clearly determine what the objectives are for your trading system as a whole. Secondly, determine the risk you are willing to take for each of the system you use.

Many traders do not even do these two basis tasks well.

Thirdly, you can simulate different position sizing mathematical algorithms to determine which possible algorithms will meet your objectives most effectively.

And fourthly, apply this rule-based algorithm to your trading system without exception or exclusion.

In the second part of this article, we look at why probably 95% of common traders foolishly ignore the mechanics of position sizing at the cost of their likely failure in the market almost every time.

Follow our live analysis further at mPower Algorithm and mPower Trading and use the advantages of the right stock and sector selections to blend into an optimum position sizing of your own individual portfolio.