Position sizing basically refers to the size of a position within a particular portfolio, or the dollar amount that an investor is going to trade. Investors use position sizing to help determine how many units of stocks they can purchase, which helps them to control risk and maximize returns. Investors should be aware that even if they use correct position sizing, they may lose more than their specified account risk limit if a stock gaps below their stop-loss order. If increased volatility is expected, such as before company earnings announcements, investors may want to halve their position size to reduce gap risk.
Using correct position sizing involves three steps:
- Determining proper position size - For example, $1000 per trade
- Determining trade risk - For example, I will buy the Facebook stock at $150 and place a stop-loss order at $120, the trade risk is $30 per share
- Determining account risk - For example, I have $50,000 on the account and my decision is to set my maximum account risk at 2%. This means that I cannot risk more than $1000 per trade and even if I lose 5 consecutive trades in a row, I only lost 10% of my investment capital
Traders and investors usually take a random position size, in my opinion, these are not valid ways to determine position size. The trader or investor who makes money on a consistent basis generally follow a a written trading plan. If you have a position sizing plan you are on a good way to become a successful and profitable investor or trader. How much of your portfolio should you risk on any one trade depends on your trading style and risk tolerance. Goals should be realistic according to your trading style and risk/reward ratios. Some traders on the stock market will not take a trade unless the potential profit is at least four times bigger than the potential risk. Rules for trade entries and exits are one of the major factors of the successful trading plan. Professional traders very often lose more trades than they win, but by managing money and limiting losses, they still end up making profits. Lots of investors and traders are concentrate only on "BUY" signals and they don't know where to exit, you should know where your exits are before you enter a trade. One of the mistakes that they usually make is they don't want to close their positions if they are down because they don't want to take a loss. Ignoring a stop loss, even if it leads to a winning trade, is bad practice. Exits are far more important than entries for the position sizing plan and I would always recommend to never risk more than 20% of your portfolio on any investment. The successful investing/trading is not gambling and I recommend trading a model or a system where the rules are clearly defined. Using someone else's position sizing plan does not reflect your trading or investing characteristics and each trader or investor should write their own plan. For larger accounts, there are some alternative methods that can be used to determine position size. A person trading a $500,000 or $1 million account may not always wish to risk 5% on each and every trade. They may have many positions in the market, they may not actually employ all of their capital, or there may be liquidity concerns with large positions. Mental preparation is also one of the important factors that should be included in the position sizing plan. If you are not emotionally and psychologically ready to trade big amounts, it is better to trade smaller amounts. In order to achieve the correct position size, we must first know our stop level and the percentage or dollar amount of our account we are willing to risk on the trade. Once we have determined these, we can calculate our ideal position size.