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Trading – The importance of Position Sizing in your trading system: Part 2

Wed 16 Jan 2019

 

In the first part of this article, we looked at why position sizing can single-handedly give a trader the biggest benefit of being very successful in the long run and some of the methods one can use to optimise the position sizing of trade positions in his portfolio.

In this second part, 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.
It is a known fact that because of the importance of position sizing, most elite traders and active fund managers in institutional funds leave the stock selection analysis of their portfolio to other researchers and focus instead on the money management of those positions in their portfolio.

Asset allocation and diversification have been proven to be one the key success factors of top institutional funds over the long run (instead of picking the exact two winning stocks they invested in) and retail traders/investors could replicate this portfolio method into their trades.

 

Hence, while a trader could do all the work in researching and stock picking himself (regardless of using any methods whether its fundamental, technical or quantitative), it may be better to use the stock picks of a very reliable education/trading advisory/trading service instead and adapting an appropriate position sizing in your trades and focus on money managing the trades instead.

The cost of such service(s) may be worth it if it can help to achieve the overall objective of your trading with the least effort and time involved on your part.

Of course, only you can decide on which method above would best be suited for you taking into account your cost, trading objectives and your own risk appetites.

 

Most traders foolishly at the cost of saving some little money subscribing to a good advisory/trading service would prefer to lose a much bigger amount in the market thinking that they prefer to lose on their own works and stock picks.

This is foolhardy thinking. If you can’t do the work as best as others in picking the right stocks selection, invest some money into a very credible good education/trading/advisory service.

You can also on others’ free service but do make sure these free services are good as “free” is a hazardous word in the world of trading.
If your stock selection is taken care off, you can then spend more time to manage and rebalance your own portfolio instead like the big institutional funds.

However, if you prefer to do all the work yourselves in picking the right stocks and managing and rebalancing them, make sure you spend at least equal time to the two components above of your trading system.

As mentioned earlier, entry and exit price at the correct price level with the right position sizing is as crucial as picking the right stocks for success in the long run.

Sure, some traders may hit one or two “jackpot” trades in the short run and misleadingly think that it was their skills not knowing that it was just their luck and as we all know, lady luck seldom comes often in the market.

 

Elite traders instead rely on a trading system that balances rewards and risks, which is the only preferred method for many top trading individual traders and institutional funds in the market.

Many top trading funds in the world uses rule-based trading system like the use of an algorithm trading system to preserve their trading edge in the trading world today.

 

When can one add to their core positions in trades in the market? Most common traders would normally enter their stock trades by taking a position, riding on it and then liquidating it all at once.

However, note that as position size increases, there may be insufficient liquidity in a market to allow such an approach.

Moreover, there are valid reasons for moving beyond this simple model of adding position for stock market investors. For example, as price moves in favour of the initial position, there will be opportunities to increase the profit potential through adding or pyramiding to the position.

 

Here are some guidelines for traders to follow if they want to increase their position size after entry:

  • A trader should always add to positions in the direction of the market. This means that if you have a long position, you add to your position as the market moves up.

 

  • When adding to positions, always add successively smaller amounts to your position. Most stock market investors may do the opposite and letting their fear of losing out and herd mentality takes over.

 

This method is called pyramiding as your position is built like a pyramid with the largest portion at the lowest price and smaller portions at higher prices.

 

  • Traders should not add to their position against the market if they are purely trading their portfolio. This is called averaging down, because your average cost is reduced.

 

Only stock market investors who are investing based on fundamentals should consider this approach and have ample capital and time to do it.

 

 

 

Another point to consider is where to enter the trade for the best entry position?

Some traders and investors like to enter their trades before a break out, some on the break out and some on the pull back after the break out.

One suggested strategy is to take one third of your position in the pattern, one third on the break out and the final third on a pull back if it occurs.

 

This has the advantage of positioning a trader at least partially in the best moves and is a good rule from a discipline point of view.

However, the strategy should be fine-tuned to your own trading style and psychology.

As long as the stop loss level has been decided, it’s up to the individual investor or trader to decide on the quantum of their entry and subsequent add-on position levels.

 

Follow our live market 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.