Position sizing – the amount an investor or trader holds in a single investment in relation to their overall portfolio or trading account – is a topic that many traders and investors do not pay enough attention to. Very often, a large loss involves either an overexposed position, extreme volatility, or a potent combination of the two. Position sizing is both the first and last line of defence against a down-and-out portfolio.
When it comes to position sizing, there are two opposing schools of thought. The first school believes in position size consistency, with the goal of removing any overconfidence bias and allowing for measured and optimisable results. The second argues that not all trading ideas are equal – so why should our position sizes be?
Both ideas have merits. It makes no sense to hold equal amounts if we believe one stock clearly has superior fundamentals or technical set-up, yet the downfall of many a newcomer is putting 80 per cent of their cash to work in a single stock. Just like passing a driving test does not make an expert driver, position size discretion can only be earned with experience.
Position sizing for goals
Our position size ultimately depends on our goals and risk per trade. A trader who is aiming for a gain of a few per cent is likely to take a larger position as a percentage of their portfolio, because they are risking a smaller amount of capital. An investor who is willing (though not wishing) to see a 50 per cent drop in the value of their investment is not likely to use the same percentage.
Both the timeframe and the goal matter. A fall of 20 per cent requires a 25 per cent gain to get back to break-even, yet a 30 per cent fall is now left requires a near-50 per cent gain. Fighting those numbers over the long run is not a great trading strategy.
Many investors scale in positions, and they may commit more capital as the price becomes lower, and the valuation more attractive. They believe they have the fundamental edge and can take on that risk, whereas the trader is playing their technical edge over the long run.
If we imagine ourselves on one side of a valley, and we need to build a bridge to cross it, we can start with a pile of wood that would be our portfolio. Every trade we make, we either receive more planks of wood in order to build our bridge further, or a rock that destroys our bridge proportionately to the size of our loss. It makes sense that we would want more planks of wood than rocks, and bigger planks than rocks.
By taking big trades, we risk destroying our bridge and setting ourselves back, but through smaller positions we are able to incrementally build our bridge in a sustainable manner. This is what trading is all about.
Deciding on sizing
Assume we have a trading account of £50,000. Our goal is to grow the account, but we also wish to not take on too much risk. It’s important to understand how risk changes as we receive feedback from our trading. If we start with a position size of £10,000, this gives us a portfolio risk of 20 per cent. Stocks are only ever one bad RNS away from shareholders losing 100 per cent of their stock value – think back to Patisserie Valerie in October. However, if we are running a 20 per cent stop-loss then our risk per trade is £2,000 – or 4 per cent of our account.
That’s not huge, but if we have five losing trades in a row, we are now at £40,000 and 20 per cent down. If we have a 50 per cent probability on our trades, no better than a coin flip, then we would be looking at (1/2) to the power of 4, which is 6.25 per cent. Unlikely – but not impossible.
Whilst not disastrous, we now need to reassess our risk. A position size of £10,000 now gives us a portfolio risk of 25 per cent, and a total risk per trade of 5 per cent.
We are also not including the psychological risks involved. Nobody likes to lose, and losing is tough – especially when it occurs with a material fall in the value of our portfolio. This is why correct position sizing is required not only to protect physical capital but psychological capital.
In the scenario above, the risk per trade has increased by 25 per cent despite the trader losing. This is exactly the opposite of what we should be doing – scaling up risk when winning, and scaling down risk when losing.
Professional traders would never risk 5 per cent of their equity on a single trade because a few bad trades could, quite literally, end a career. But for those who aren’t 100 per cent reliant on their trading portfolio for income then 5 per cent can be reasonable. Should anything bad happen, the account can always be topped up from elsewhere, although it is wise to make sure the top-ups are not too regular and propping up a poorly performing portfolio due to bad trading skills.
Topping up an account from elsewhere may relieve stress and anxiety should anything go wrong, but done too often it can become a reinforced bad habit, and if one does eventually go full-time on the stock market then there will be no more fresh funds coming into the portfolio. If we reduce our position size to £5,000 then we can see how both the portfolio risk and total risk per trade changes:
Instead of five losing trades leading to a loss of 20 per cent, the trader risking 2 per cent of equity per trade now needs 10 losing trades to hit the same drawdown.
Ten losing trades is still possible, but statistically it is much more unlikely. Again, if we assume a probability of a coin toss then we would be looking at 1/2 to the power of 10, or 0.1 per cent when rounded up – much less likely than the previous 6.25 per cent chance.
By halving the position size, we have now allowed a much greater risk of early failures in our trading system. We have built in failure and through our position sizing alone we have skewed the risks and chances of success greatly in our favour. This is why position sizing is a crucial building block of every trading system. You can have a probability and success rate of 70 per cent on every trade (I have never heard of a rate this high before) but if the account is blown within the first 20 trades it’s not going to matter.
The goal of position sizing is to give a trader the best possible chances of winning in the long run. We need to play to win, but capital preservation is of paramount importance. This is why serious traders are always focused on risk first because they know no capital means no trading.
If we did hit 10 losing trades in a row, then this is the situation we would be looking at.
Again, our risk per trade has increased by 25 per cent. However, instead of jumping from 4 to 5 per cent we have moved from 2 to 2.5 per cent. The lower position size in this instance has given us more room for error in our trading account.
A reduction from a position size of £5,000 to £4,000 would again place our risk per trade at 2 per cent, or we could scale it back even further. We should be trading harder and stepping on the gas when winning and decreasing our exposure and our risk when losing. A good way we can do that is through compounding and downsizing.
Compounding and downsizing
The amount to risk depends entirely on you and your own circumstances. Concentrated positions can achieve growth more quickly, but also decimate an account and put the trader on the back foot within just a few trades.
Even at 5 per cent per trade, we only have 20 bullets before we’re out of ammo and have blown our account.
However, there is a way we can risk 5 per cent per trade, and benefit materially from successes, and protect our account when losing. Compounding our position sizes alongside our success allows us to scale up our capital deployed in line with our account. The other benefit is that we reduce our position sizes when losing, in order to protect our trading ammunition.
As we can see in Figure 1, by adding to our position sizes we create an exponential equity curve, but still avoid blowing our account when we are losing. Over 20 trades, the position size that compounded and downsized after each trade yielded a return 1.3 per cent higher than the position size that was consistent. Scaling is a great way of building wealth more quickly as a successful strategy is rewarded much faster than if we kept all position sizes the same.
It also allows us to adjust gradually, as suddenly increasing a position size to double is a big psychological jump. Thinking in percentages, rather than monetary value, is an excellent way to disconnect from the reality of the money we are trading.
Losing £5,000 feels very different to losing £50,000 on a trade, but if you’re up 5 per cent then you’re up 5 per cent. It doesn’t matter whether it’s £10,000 or £100,000. An account up 5 per cent will always be exactly that – 5 per cent.
Another positive of compounding growth is that we build our bridge sustainably, rather than in a high-risk manner. A bridge that is not built on a solid fundamental basis is at risk of collapsing. We should aim to build our bridge (and our portfolio) both carefully and slowly. Many traders have amassed a large sum of wealth through speculation and high risk, but unfortunately lost it all just as quickly through the same speculation and careless attitude.
Variable positions
Beginner traders should keep position sizing and risk constant when starting out. This is because consistent trading gives consistent results. Consistent results allow us to review the data and search for errors and how to improve. For example, consistent losses when trading a particular technical set-up tells us that either our entry or our exit is wrong, or even that we have no edge to trade.
Once we have a consistently profitable strategy, we can begin to manipulate our position sizing. Firstly, we want to put more of our capital to work in our most profitable set-ups. Secondly, it makes no sense for a trader with a six-figure trading account to be trading the same position sizes in both a £20m market cap company and a £200m market cap company. Both the volume and liquidity are going to be completely different.
When our portfolio grows, then it’s essential we adopt variable position sizing. If we are holding more than the average daily volume of a stock, which may easily just be a few thousand pounds’ worth of shares, then we are exposing ourselves to a potentially large fall. If that company releases negative news then being able to exit at our pre-defined exit price is going to be unlikely. Illiquid stocks and bad news can create many sellers rushing through a crowded exit.
We also want to avoid owning so much of the stock that we have to move the price downwards before we’ve sold our entire position. As traders, we are risk managers, and so we must always look at total daily volume before deciding on our position size.
Adjusting for risk
We can vary our position sizes due to the probability of success on the trade and adjust for liquidity, but we can also adjust our position size for risk per trade taken.
The focus here is not on the position size, but the risk itself and we can then manipulate our position size to do this.
If we assume that our consistent risk per trade is £1,000 then on a £5,000 position that is a 20 per cent stop. If we only wanted a 10 per cent stop on that trade, then we would obviously double up on our position size as 10 per cent of £10,000 is consistent with our risk per trade.
However, if we looked at Stock X and we wanted to buy at 9.5p, and wanted to adjust our position to keep the risk consistent, we need to know both our entry and our exit. We may believe that the trade had support at 7p, but we know that amateur traders place their stops exactly on the support line. We decide to place our stop below that stop-loss liquidity at 6.8p. We want to risk £1,000 and we need to know how to calculate to adjust for that risk.
First of all, we’d need to know the risk per share, which is 2.7p. We are risking £1,000 for 2.7p per share, which we can use to tell us how many shares we need to buy.
Very simply, we divide our trading risk by the risk per share (£1,000 / £0.27) which gives us 37,037 shares at a cost of £3,518.52.
To adjust a position for risk we divide our monetary risk by the risk per share taken, which is calculated by taking our entry minus our exit
Position sizing for risk is a great weapon in the trader’s arsenal, as it allows us to get creative with our positions – it’s no good employing 10 per cent risk when support is 15 per cent away from our entry price. We are just asking to be needlessly stopped out. By decreasing our position size we are allowing ourselves breathing space in the trade and potentially increasing our probability of success for the same risk per trade taken.
Position sizing is an important part of any trading system and not one to be taken lightly. When deployed correctly, it allows us to take on any stock regardless of its volatility or liquidity, and protects our downside. Ultimately, a trader should first define their goals and their risk profile and build their trading system and position sizing around that.
