Position sizing is among the most important aspects of profitable trading more important than using a particular strategy itself.
What is Position Sizing
Position sizing is the total number of shares or volume of a trade you take when trading a stock, or how many contracts you buy when making a futures trade.
It’s one of the most important parts of your investment or trading strategy. It’s an essential element of success for every trader.
Position size is not randomly chosen, nor based on just how certain you find yourself a trade will work out. Rather, position size is determined by a simple mathematical formula which helps control risk and maximize returns on the risk taken.
Why is Position Sizing so Important?
Assume that you had ₹50,000 to trade. You really feel confident that stock ABC, currently priced at ₹10, is going higher. You make a decision to buy 3000 shares, costing ₹30,000. Earnings come out the following week and the stock drops to ₹9, and proceeds to decline over the following week, finally settling at ₹5. You realize you were wrong and close out the position, for a loss of ₹15,000 in a matter of weeks.
There are two major problems here. The position size, 3000 shares, is random rather than calibrated to the account size. The risk was also not controlled in any way when the trade was placed. This is why your position sizing rule is the most important trading rule. It determines the size of your position. It tells you how many shares, lots, or contracts, to buy or sell for each trade that you put on.
There isn’t a set in rock rule for the size of your position. A lot of personal factors like the size of your account, your risk tolerance, as well as your experience, all need to be considered while deciding on how big of a bet you should make on each trade. That said, “risk of ruin” — that is, the possibility that you’ll erupt your account if you hit a “cold streak” — decreases considerably as your risk approaches 2% or less of your portfolio.
Let’s look into some position sizing models that try to maximise profit while preventing risk of ruin.
Fixed-fractional Position Sizing
The concept behind fixed fractional position sizing is that you base the number of contracts or shares on the risk of the trade. Fixed fractional position sizing is also known as fixed risk position sizing because it risks the same percentage or fraction of account equity on each trade. For example, you might risk 1% of your account equity on each trade. Position Size is then calculated as:
Position Size (No. of shares) = Account Risk / Trade Risk
Where Account Risk is the maximum amount of your total account you can risk per trade.
Trade Risk is maximum amount you can lose per trade.
For instance, let’s say you have ₹100,000 in your trading account. Then 1% of your trading account is ₹1,000. That becomes your Account Risk.
Let us say you want to buy a stock at ₹100 and your stop loss is ₹98. Then your Trade Risk is ₹2.
Calculate your position size according to the amount you can risk.
Position Size (No. of shares) = Account Risk / Trade Risk
₹1000 / ₹2 = 500
Hence, trade 500 shares. In this case, no matter which way the trade goes, the maximum you are losing per trade is ₹1000.
This is a popular position sizing model because it is straightforward and simple to put in place. It is also favorable to new traders as it does not need a trading track record.
The same concept can be applied to Futures where instead of shares we have to consider contracts.
Position Sizing With the Kelly Criterion
The Kelly criterion is a formula used to figure out the optimal size of a series of bets. Both bets and trading positions cope with probabilities. Thus, the Kelly Criterion is a natural candidate for position sizing.
There are two basic components to the Kelly criterion: 1) the win probability, or the probability that any given trade you make will make a positive return, and 2) win-loss ratio, or the total positive trade amounts divided by the total negative trade amounts.
Kelly Percentage = W – [(1 – W) / R], Where:
W = Winning probability
R = Win/loss ratio
The Kelly Criterion is efficient only if the inputs correctly represent the future. The one problem with all of this is the Kelly criterion makes a number of assumptions and, as any experienced investor will tell you, in the real world these types of assumptions often count for nothing.
Summary
Whether we risk a percentage of our account on each trade or choose a Kelly Percentage Criterion, there are dozens of more options. However, there are no binding rules – only those which you set yourself.
But the important thing to take away from Position Sizing is that it is a way to control risk to your portfolio, and many times novice traders make the mistake of haphazardly choosing their position sizes and risking a big chunk of their amount, many times even losing so much as to never venture into trading again! Hopefully, after reading this article, you will make sure that you always select the proper position size for your trade.