First off, let’s start off by looking at position sizing. Position sizing, in its most basic aspect, is the dollar amount being invested in any security on any trade. Every successful trader will have pre-determined rules for their trading account. Obviously, each individual position size will be based upon account size, risk tolerance and belief in trade. With emotion being the cause of so many traders being unsuccessful, having hard and fast rules to fall back on gives traders a higher degree of profitability. There are many different schools of thought on position sizing, usually varying from asset to asset. There have been many studies which have shown those who implement some form of position size while trading lost less money than those who did not. There is one constant theme intertwined within all successful traders and that is having discipline and position sizing certainly falls under that category.
Why is position trading so important? Ask any trader and they will tell you that a high amount of beginning traders do better when paper trading than once actually live (at least initially). The reason being the realization of losing ‘real’ money after going live versus paper losses. Something happens to a great deal of traders after the money lost becomes tangible. Also, knowing how to deal with profits doesn’t make a successful trader insomuch as being able to handle losses. Being able to think and act clearly and concisely in the face of danger (ie trade going against you) saves more accounts than any other single trait. Remember, there are five outcomes of every trade: big profits, small profits, scratch, small losses and big losses. Being able to take big losses out of the equation will, at the very least, give every trader more bullets in the gun. Position sizing sets the floor on what you are willing to lose on a single trade.
When determining your position size for your trading account, you must take into account two very important things: yourself and the market you are going to trade. Being able to identify your personal strengths and weaknesses will only help you come up with a practical and probable willing trading plan. In conjunction with knowing yourself, having a firm grasp on the idiosyncrasies of each security or asset will only heighten your success rate.
Let’s take a look at one specific formula for position sizing and proper money management, the Kelly Formula or Kelly Criterion. The Kelly Formula was designed by John Kelly who worked for AT&T and it was originally used for long distance data transmission. Traders got wind of it once it was published and saw that it could be used as an optimal betting system. There are two basic components to the formula: win probability and win/loss ratio. Your win probability is calculated by dividing the number of winning trades by your number of total trades. The win/loss ratio is found by dividing the average gain of winning trades by the average loss of negative trades. After finding these numbers, the Kelly Formula is:
K% = W – [(1 – W) / R]
where W is your winning probability and R is your win/loss ratio. This formula will give you how much you should appropriate per trade. One must remember that this formula takes the trader and the market as a constant, which doesn’t really happen. Many traders will retest their trading on a monthly, quarterly, annual basis to make sure they are using the correct position size.What do we mean by knowing yourself? In the most basic sense, it is knowing what you are good at and what you are bad at while trading, along with knowing your actual account. For example, a person who doesn’t like volatility should not trade a volatile product (the converse would be true as well). Taking account size out of the picture, you should know what things you do well before trading. Knowing if you can make a decision quickly, be able to act fast off news, read charts technically at a glance are just some of the things you should know about yourself before trading. Once you know what things you do well, and what things you don’t do well, you can determine an appropriate stock, bond or commodity to trade.
Besides knowing your strengths and weaknesses, your account size, risk tolerance and belief in a trade will help determine your position size. Obviously, someone with a smaller account has to have different parameters for their account than someone with more funds. The small account can have the same percentage stop loss on each trade as a big account, but being able to be profitable right off the bat is more important for the smaller account than the big, although I would add that it is important to the big account as well. The reason I say this is because the smaller account already has a different attitude on staying than the big account.
Risk tolerance is another important aspect of position sizing you should know before trading. Risk tolerance is the amount of risk you are willing to take in your account. Besides your personality, age and account size will help determine your risk tolerance. Generally, the amount of profit you are looking to get will equal the amount of risk you will be taking on. For example, if you are looking to double your account (a 100% increase), you can expect a complete loss (a 100% decrease) as your risk. It is very rare to be able to find a trade where your risk is 5% and potential profit be 400%, it just doesn’t happen. Many beginning traders believe that they can see a 50% return with little to no risk, which isn’t realistic. Having a realistic view of the amount of risk you want to put on before you trade will help you be ready should the trade go against you. Position sizing helps you pre-determine what risk you are willing to take before initiating a trade. If you know that you are only willing to risk $500 on a trade, you know where to put your stop as well as be prepared to exit, if needed.
Another important facet of effective position sizing is your belief in a trade. Many successful traders have different grades or rankings for each trade. They will use an A+, green light or 1 (or whatever ranking system they use) for each trade and that will determine how much money or what size they want to put on for the trade. The idea being trades that you believe have a higher percentage of working in your favor should be delegated a higher percentage of funds. This works both in fundamental trading as well as technical trading. Some technical traders put on a larger position if they see a triple or quadruple top (or whatever metric that particular technical trader uses) because they believe that has more of a chance of going down than something just with a single or double top. The general idea is trades that you believe in should be a bigger bet than trades you feel less confident about.
By Henry King