Position Sizing. The quantity factor
Position Sizing, the question of how much, or what quantity? One of the most ignored aspects of trading by new traders. Generally with new traders, or traders with little experience I have seen a desire to use the entire capital for trading. And some of them who understand that they cannot risk all, try to minimise the risk by manipulating their stop loses. Now stop loses are an important part of setup that we will discuss in in the next post. But in brief what do stop losses mean? Its a point that tells us our system is no more valid and we should exit. So its not really a good idea to tamper them and bring them close to entry just go use the whole capital.
So the first thing a trader should lose is the idea of using entire capital every trade. How much capital to use, what quantity to buy, these are defined by position sizing. Position Size, also like many other concepts is dependent on the risk we take.
To define the position size a person has to first know the point at which he/she will accept that the setup has failed and its time to run (stop loss).
There are many methods that people use to calculate position size. The two most common methods are
- Factor of Risk
- Factor of Drawdown
Position Sizing Based of Risk:
To calculate position size as a factor of risk lets assume a trader has a capital of 100,000 and risk appetite of 2 percent. This means that the trader is ready to lose up to 2000 per trade. So now say have a stock which might trigger a long entry at 300, and we know for sure after entry if the stock moves back to 295 the setup has failed and its time to exit. This gives us a risk per share of 300-295=5 bucks. Since we already know that the max permissible loss for our system is 2000. Therefore to calculate the position size we simply divide 2000/5. This will give us a quantity of 400. Now in this example we cannot buy 400 because, as it will require 120,000 while we have just 100,000. But I hope you get the point.
In futures trading the calculation will change in a per lot basis. So risk per lot and no of lots will be calculated instead of individual quantity of stock or commodity.
Position Sizing Based on Drawdown:
In systems based on drawdown a particular amount is assigned to a single lot or “x” quantity of stock. So suppose we are going to use 50,000 per lot, so it simply implies that we will trade 2 lots always till we cannot turn our 100,000 to 150,000. Once we have 150,000 we start trading 3 lots. On onset this looks simple but to find out how much money to allot per lot, we need to know the drawdown of a system.
For example say we assign 50,000 per lot to a commodity whose margin requirement is 35,000. In this system, we will go out of business once we have a drawdown of 15,000. And one thing to always keep in mind in trading or any business is that the last thing we want to do is get out of business.
In boxing, Falling down is not where we lose but we lose when we are unable to get up. Similarly in trading our position size should be such that we can get up to fight after we fall down again and again and again.
If you don’t bet, you can’t win. If you lose all your chips, you can’t bet. – Larry Hite