Position Sizing – The Art of Controlling Risk and Making Money

What is position sizing? In its basic form, it is the percentage of your account value you’re willing to risk on each trade. There are many ways to build a sizing model—from very complex to very simple. Here’s the basic formula to help you understand this concept.

The percentage of your account value you’re willing to risk divided by difference between Current Price (CP) and Stop Price (SP) equals the amount of shares to position.

Account Balance: $100,000

Risk Amount: 1% of Account Balance or $1000 (rule of thumb is not to risk more than 2.5% on any trade)

Current Price (CP) = $36.78

Stop Price (SP) = $32.14

(CP) $36.78 minus (SP) $32.14 = $4.64

Risk Amount: $1000/$4.64 = 215.52 shares (rounded 216 shares)Total Amount of position = 216 shares * $36.78 (CP) = $7944.48

This will give you the basic understanding of this concept. Before we move on to more advanced uses of this tool. It is important to understand. The two most important parts of trading are POSITION SIZING and TRADING PSYCHOLOGY!!!

The ideal portfolio management is to be able to add risk when you are winning and reduce risk when you are losing. I said that this is “ideal”, it doesn’t always work that way. For some reason we tend to start investing more when the prices go down, we feel if it was a good investment at $20.00 it should be great at $12.00. The industry has taught us that we should “buy low and sell high”. This works if you have a full knowledge of the industry and all of the nuances that go along with running a company but for the average investor this is a “value trap” most of the time. This type of thinking is a result of most of the industry being trained during the last bull market and from 1982 to 2000 that strategy worked pretty well, with a few exceptions. This is all fine and dandy, when things go down and then proceed to go back up. But we both know over the last ten years, not everything comes back up or if it does it could take years. So how do you protect yourself and still take advantage of opportunities.

This one tool can absolutely change your trading experience. What if you could trade any position just on a random basis and still make money? Dr. Van Tharp, the person responsible for a lot of the work done on Position Sizing, has proven just that. They created a trading system based on a coin flip that would put you in a position either long or short. Using that trading system and position sizing they made money. Now I am not saying this is how to make money but think about what you could do if you had a decent trading system and added position sizing to the mix.

There are several different ways you can create your position sizing algorithm. Here are a few examples.

Set percentage position sizing – you always have a set percentage for each position you take. For example, let’s say that you decide you always are willing to risk 8% on each trade. William O’neil’s CANSLIM approach states if you buy a position and it goes against you by 8% you should sell. So now, every position you take you should know how to calculate your position size. Assuming you are risking 1% of your portfolio and it is worth $100,000 that equals $1000 you can risk on each position. So if you bought a stock at $56.98 your stop would be 8% ($4.56) below that price or $52.42. Take the amount you are willing to risk $1000 and divide by $4.56 and you get 219.298 round down to 219 shares. Total position equals 219 shares times $56.98 or $12,478.62. It is that easy. There is no excuse not to have a predetermined exit point before you take a position.

Support level position sizing – based on the support level of the chart is where you set the stop. This works exactly the same way as set percentage position sizing you are just using a different method to come up with your stop price. This method gives me a little more comfort knowing there is some support that has to be broken before you hit my stop. I usually give myself a nickel or dime difference from where support is and where I set the stop. For example, if the support level is $34.57, I will usually set my stop at $34.47. I have seen too many times where the price will break the support by a couple of cents just before it turns around, so that is why I give myself a little cushion.

Volatility level position sizing – based on the Average True Range (ATR) of the stock. You can use any time frame for ATR but I tend to use 20 days. Average true range (ATR) measures the volatility of the stock. By understanding the volatility of the stock you can decide on how far from the current price to set your stop. The first thing you have to do is find the ATR 20 day for the stock. Stockcharts.com is a great place that charts the ATR. Let’s say the ATR is $1.45, and then you need to decide on the multiplier. I have used 1.5X for my shorter term trading systems. Remember the tighter the stop the bigger the position but also you typically have a shorter holding period. So for this example you would take $1.45 and multiply it by 1.5 and you get $2.175 round up $2.18 as your factor. The stock is currently pricing at $38.79 minus $2.18, so your stop is $36.61. Then you use the same method to figure your position sizing.

These are three ways to calculate your position size for each of your trades. The next step is to apply this method to portfolio management. The term that you will hear when it comes to portfolio management and position sizing is money management or asset allocation. Basically, what this means is how much risk is in the portfolio and are you diversified. After you have mastered the basics of position sizing then you need to find a way to incorporate this into managing multiple positions.

How do you account for multiple positions when you are position sizing? There are several ways to create your algorithm for portfolio management. Let’s start with the basic position sizing formula and add additional positions. Here is an example, your portfolio is $100,000 and you have ten positions. The risk per position is 1% of the portfolio value. Common sense would say you are currently risking $10,000 ($1000 X 10 positions) if all of the positions go against you. This is correct if you use a straight position sizing algorithm. The problem with this straight position sizing model, is it does not take into account the correlation of the portfolio. If you have bought ten energy stocks then it is very likely that if oil goes down that they could all go against you at the same time. Even if you are diversified and have stocks that are in ten different sectors this could still happen to you. Approximately 85% of a stocks movement is determined by the major indexes. So if the S&P 500 went down the statistics show that at least 8 of your stocks would follow.

So how do you manage your risk in this situation? Let’s take the same example as above, $100,000 portfolio and ten stocks, risking 1% per position. Now let’s change the parameters a little bit. For each of your positions that you own reduce the portfolio by that risk amount. Here’s how that would work. The first position’s risk amount is $1000 or 1% of $100,000. The second position’s risk amount is $990 or 1% of $100,000 minus $1000 the risk already taken on the first position. Here’s how it works for ten positions.

First position: $100,000 * 1% = $1000 risk

Second position: $100,000 – $1000 = $99,000 * 1% = $990 risk

Third position: $99,000 – $990 = $98,010 * 1% = $980.10 round down $980 risk

Fourth position: $98,010 – $980 = $97,030 * 1% = $970.30 round down $970 risk

And so on…… to ten positions.

You keep subtracting the risk you have in the portfolio after each position you take. So for the same ten positions you will have $9,562.00. This is not a big difference but is does reduce the risk.

The next step is to take the actual change in the portfolio value. The previous example assumed you took all ten positions at the same time, so there was not additional fluctuation in your portfolio. We all know that’s not how it happens in trading. So we have to add other parameters to the calculation. First let’s define these parameters.

Beginning Portfolio/Capital = this is exactly what it sounds like. This is the equity that you initially invested. In the example above this equals $100,000.

Current Portfolio Value – this is the value of the portfolio at the time of the trade. It could be the previous close or the intraday value. You would need to decide on whether to use the close value or intraday value for your calculation.

Risk Reduced Portfolio – this is Current Portfolio Value minus the current risk you already have in the portfolio.

So here is the formula for position sizing when it relates to portfolio management. First you have to calculate your Risk Reduce Portfolio. The calculation for this is the Current Portfolio value minus the sum of each individual stock’s risk. Here is an example, if you have three positions and your current portfolio value is $99,600.00, and the risk of your first three trades were based on the beginning portfolio then you would take would add $1000, $990, and $980 together to get your total risk of $2970.00 subtract this from $99,600 to get $96,630. The next step is to calculate your position size based off of this amount. $96,630 * 1% = $966 Risk Amount.

As you add positions (risk) to your portfolio then you subtract that total from the current portfolio value to get your risk reduced portfolio. Also, when you close a position it should add the risk held by that position back into the risk reduced portfolio. This will help when your trading system has not been working in the current market conditions. So as your portfolio value goes down, so will the amount your risk. There is a variance to this strategy, you can add up the risk that you have on your long positions and subtract that from the risk you have on your short positions. The theory behind this strategy is by being both long and short you should not have positions that correlate. On a swing trading type system, I do not recommend this because it has been my experiences when my indicators are not working, it does not matter if I am long or short all the positions seem to go against me.

Now that we have discussed position sizing to help you reduce risk, let’s talk about how it can help you make more money. One of my concerns about position sizing was the ability to segment capital, for the purpose of taking more risk with a certain amount of capital but do it in a disciplined way. You could always buy more if you thought the position was a great trade but that is not what I am talking about. I wanted a discipline way to take more risk when things were going my way. After reading several articles by Van Tharp and the book Trend Following, How Great Traders Make Millions In Up or Down Markets by Michael W. Covel, I got very interested in Ed Seykota. He is a very successful trader and he coined the phrase “market money”. He discussed a way to use “market money” in your position sizing model. Basically, what this means is you take your profits and separate it from your beginning capital. You maintain the same risk on your initial capital of 1% but you can risk more on your “market money” such as 3% or 5% depending on your objectives.

Here is how it works. Assuming your portfolio started with $100,000 and you have grown it to $112,000, then you would take 1% of $100,000 or $1000 and 5% of $12,000 or $600 for a total risk of $1600. See how this is different than if you just risked 1% or $1120 on your total portfolio. This allows you to risk more as the trend moves in your favor.Z

The next step is to decide when to convert “market money” to trading capital. The biggest problem with this position sizing model is the potential to incur the most risk at the top. This is always going to be a concern but here is a way to minimize that possibility of it happening. Reset your trading capital every quarter. What does that mean? It means take your portfolio value and rather than having beginning capital and “market money” you convert it all too beginning capital every quarter. For example, $100,000 is the beginning capital and you have grown it to $112,000 the next quarter your beginning capital will be $112,000. So now you are only risking 1% of $112,000 until you have grown your account again. The frequency of when you convert from “market money” to trading capital is completely up to you. This could be done on a monthly, quarterly, semi-annual or annual basis.

Position sizing can truly be a powerful tool for trading. There are a number of ways to build a position sizing algorithm to obtain your objectives. Ultimately it is up to you to decide what you want to accomplish and how much “portfolio heat” you want to incur. Remember you can’t make money without losing money. It’s just like breathing you can’t only breathe out at some point you have to breathe in. As with all trading tools they only work if you consistently use them.