Among the many mysteries you’ll encounter as you progress through your trading career, the mystery of effective position sizing will undoubtedly be one of the biggest and most confusing. The mystery seems simple enough to solve, right? Since the solution is really just the answer to the simple question, “How many shares should I trade?” it should be a piece of cake to figure it out. It’s not as simple as you might think though, and here’s why:
When traders, especially new traders, question what size position they should take, most often they are only questioning when a position is too large. Nobody wants to take on more risk than they can handle, right? This is good, but there is another side to the story. Traders don’t often consider what will happen when a position is too small.
Profitable trading is 95% emotional and only 5% skill. Recognizing patterns is easy and pretty much anyone can do it with enough repetition. When you add in emotion, though, specifically the emotions of fear and greed that appear when real money is involved, trading stocks becomes a completely different animal and most people buckle under the pressure. It’s this pair of emotions that plays so strongly into what can happen if you size positions incorrectly in either direction. Let’s dive a little deeper:
If you size your position too large, fear takes over:
You will sit and watch the stock tick for tick, and probably only play your profit or loss, instead of playing the setup or the pattern. You’ll get out too soon and take an unnecessary loss in order to preserve capital, and though you might have managed your risk from a monetary perspective, you probably exited only in response to the inevitable noise, or the natural fluctuations in the stock price. With position sizes that are too large, you’ll be lucky to win 10% of your trades, and no one can make money if they lose 90% of the time! On the other hand...
If you size your position too small, greed takes over:
You’ll push it too far, trying to earn yourself what you view as a respectable monetary gain without realizing that your target might be 10% or 15% away. The effect is that the trade will most likely come back on you and you’ll end up getting out flat or for a very small loss. This too will drastically reduce your win rate, while simultaneously shrinking any gains you do make to levels that can’t possibly overcome your losses. And thus, we live and we learn. This is the crux of effective position sizing:
You must know yourself
You must know your limits, but you must also understand your own greed. If you view $300 as a respectable gain on a trade, you cannot afford to take a 200 share position on a $10 stock. In order to get to your respectable gain, you’ll need to make $1.50 per share or 15%! On the other hand if a respectable gain for you is only $80, then that same $10 stock needs to move only 4% with 200 shares, and so that might be an effective size for you. Conversely if you view $300 as a respectable gain then with a 2:1 reward to risk ratio you must view $150 as a max loss, and thus you cannot take a 5,000 share position on a $10 stock because with that position size your stop loss is only 3 cents away, or 0.30%. A fluctuation of that size is just noise in 99% of stocks.
Like most things in life, the key to effective position sizing is finding balance:
You must take a position that is not so large that you’ll be scared out of the stock by noise, but large enough that you’ll feel good with both the rate at which you make your profit and the amount of profit you make. Further, your position must be small enough that any loss on the trade will be manageable, but not so small that you’ll require the stock to move more than should be expected in order to reach what you view as a respectable gain.
So remember to consider both sides of the coin. Do not fall into the trap of only considering when a position is too large. When you find the proper balance, you’ll find yourself entering positions that consistently challenge you to honor your risk rules while also producing gains that you can feel good about.