Discussion Topic: Position Sizing Strategy
Building a successful trading career requires proper education, a lot of patience, a number of other techniques. One of such other technique is position sizing. This is a major part of money management which we have discussed earlier. In this article, I will try to elaborate an effective position sizing strategy with all its calculations. This will help you to select an optimal position size for your trades.
Winning a trade requires the support of a comprehensive trading plan. And a comprehensive trading plan remains incomplete if it does not contain a position sizing technique. Along with your trading plan, you should always have some methods to decide on position size before opening any trade.
What is Position Sizing in Trading?
Position sizing is one of the most important parts of money management. The word "Position sizing" in trading refers to the number of units you are planning to buy/sell in a particular security. It is the primary action required to limit your trade risk. You must consider your account size, per trade risk, and your risk tolerance to determine the appropriate position sizing.
There are 3 rules of Position sizing technique:
- Determine the total account risk.
- Determine the trade risk.
- Calculate the proper position size.
Don’t worry; I’ll explain all these things with examples later in this article.
Overall Trading Capital vs Active Trading Capital
You should always know the difference between the concept of overall trading capital and active trading capital. The overall trading capital is also sometimes referred to as the “trading account value”. And the Active trading capital refers to the amount you want to use for actively for trading.
Being simple, the active trading capital is the fraction amount of overall trading capital that you want to use for trading.
Ooff… Ohh… Should I not use the full amount for trading? - NO, You should not. The basic rules of money management tell us to be prepared for any unwanted situation all the time. Hence, as a thumb rule, we will only use up to 75% of the money from our trading account as active trading margin.
Hope it is clear!!
*Also Note* - Your "Overall trading capital" must not exceed 15% of your total savings. The less you bring the better it will be.
How to Select Optimal Position Size for Your Trades?
I’ll explain the position sizing strategy or technique with a small example so that it becomes easy for you to understand.
We will start by assuming that we have Rs.100,000/- capital in our trading account. Now we will process this amount through our position sizing rules.
1) Determine the Total Account Risk
As I said earlier, the total risk (i.e. - active trading capital) should not exceed 75% of the account value. Hence, your Total Account Risk for trading should be 100,000*75% = 75,000. Rest 25,000 would stand as reserved.
2) Determine the Trade Risk
Mark this rule: Your total risk should never exceed 3% of your active trading capital by summing all the open positions.
Hence, at any given point of time & considering all open positions, your total trade risk must not exceed 75,000*3% = 2250.
Why 3%?? Because even if you get hit by 10 consecutive stop-losses, you will only lose 30% of your active trading capital. And you will have enough capital to recover your losses in a much easier way.
3) Position Sizing: Calculating the Proper Position Size
So, what to do? – You must adjust your position size every time before entering into any new trade. This is why you will need a definite trading plan that will tell you the expected stop-loss points before entering into the trade. This is required for the position sizing technique to work as expected.
If you work with only 1 stock and you determine your risk for a trade is 10 points/share. Then your maximum position size would be 2250/10 = 225 unit of shares.
Similarly, if you trade only 2 stocks, then you can split per stock risk to 2250/2 = 1125. If in Stock-A, the risk is 3 point per share, and in Stock-B the risk is 5 point per share. Then position size for Stock-A would be maximum 1125/3 = 375 shares and the position size for Stock-B will be 1125/5 = 225 shares.
The more you diversify your active trading capital, you have to divide and calculate your optimal position size by using the above-shown method.
Should You Increase Position Size After Loss?
In one sentence “NO & NEVER”. Instead, if required, you must reduce position size according to your new risk capital amount.
There is a concept floats around the internet community that tells you to trade with double quantity after you make a loss in one trade. In the gambler’s circle, this is popularly known as Martingale Strategy.
This is purely a betting strategy with increasing risk on your trading account, and should never be followed in real life. The principal says as below:
- Take Trade-1 with “X” Quantity (eg:100 units)
- In case you lose the trade then take Reverse Trade-2 with 2*X Quantity (eg:200 units)
- If again Lost then take Reverse Trade-3 with 4*X Quantity (eg: 400 units)
- If again Lost then take Reverse Trade-4 with 8*X Quantity (eg: 800 units)
- And like that continue till you win.
This is also called gambler’s fallacy, where a gambler always thinks that he is having a high chance of winning in the next trade. But the reality is much different in most of the cases where the gambler ran out of money. All ends here.
Hence, you can understand how risky it may be if u don’t do your money management properly and increase your position size without thinking. Therefore, my suggestion is that you must always take calculated risks and not doing any revenge trades.
We hope that you have enjoyed the above article explaining the position sizing strategy for your trades. Be with us to explore forex trading, stocks trading, and other money-making opportunities.
Leave us some comments if you have any questions or doubts about position sizing technique, we will be happy to help you.