One of the concepts I’m often asked about by other traders is the concept of proper position sizing. I’ve blogged about this in the past, but that post still left a lot of questions unanswered, especially if you’re in that “experimental” phase of your trading career where you’re trying to feel out what works and what doesn’t. It can be difficult, even after reading that post, to “know yourself” without years of experience. To combat this phenomenon I decided to make the issue of position sizing a bit more systematic. By doing this it gives you a way to try a system, stick with it for a while, see if it feels comfortable to you, and if not, make appropriate changes.
Some people (myself included) need a system of rules when it comes to position sizing and others don’t. Some people have an innate “gut reaction” about how much size they should use when they see a potential trade, and that “gut reaction” is often a product of experience. So what do you do if you don’t have that experience yet? How do you decide which stocks are worth a ton of risk and which ones aren’t?
In my own personal struggle to “size up” my trades, I’ve found that there are really four schools of thought when it comes to risk management and position sizing. Each school of thought has its own pros and cons, and they increase in complexity from very simple to very complex. Here are the four ways to determine your most effective position size, and some things to consider with each idea:
1. Static Share Size:
In this school of thought, on every trade you take you buy (or short) the same number of shares. This is obviously extremely simple. You’re basically saying you don’t care how expensive the stock is, you will always buy 1,000 shares, or 500 shares, or whatever. In this way the most expensive stocks will generally be the most risky in terms of dollars, since they will be the largest positions in terms of dollars and given an equivalent percentage fluctuation a larger position will offer more reward for more risk.
For example if you buy 1,000 shares of a $10 stock you’ve taken a $10,000 position and thus might be risking $100-200 assuming the average intraday fluctuation of a reasonably liquid, non-volatile $10 stock might be 10-20 cents up or down. If you buy 1,000 shares of a similarly liquid and similarly volatile $100 stock there is likely no way you can get away with a 10-20 cent risk fluctuation since most $100+ stocks will have intraday fluctuations of at least 50 or 60 cents, maybe even a few bucks a share. So under the first school of thought – static share size – you let the price and the nature of the stock determine the risk.
2. Static Position Size:
In the second school of thought you will always buy a set dollar amount (or a set percentage of your assets if you prefer to use percentages instead) worth of stock. In other words you will always buy $10,000, or always buy $20,000 worth of stock regardless of the price/characteristics of the stock. This is similar to the first method except for a couple key differences. First, in this model generally speaking lower-priced stocks are going to be more risky since buying a large position of a cheap stock will require your risk tolerance to be extremely tight, most likely too tight, in order to keep risk low.
Consider a static position size of $20,000 on every trade: If you buy $20,000 worth of a $1 stock you'll own 20,000 shares. Even a one penny tick against you will cost you $400 assuming you sell across a 1 cent spread to exit the position, so being stopped out is very likely. If you want to keep your probability high, you’re probably going to have to risk at least a few pennies to allow the stock to “breathe”. By the same token if you buy a $20,000 position of a $100 stock your share size is only 200 shares. On this trade you have a much better chance of being right since you can let the $100 stock fluctuate $1-2 per share for the same amount of risk. While $100 stocks generally will have much larger fluctuations than $1 stocks, you’re still not going to be required to nail your entry to the exact penny on the more expensive stocks.
So in the end, with a static position size the cheaper stocks will be more risky and lower probability, while the more expensive stocks will be higher probability and lower risk. Of course, the caveat is that where there is lower risk there is lower reward and also this school of thought, unlike the one above does not consider the nature of the stock at all (in other words it doesn’t consider the fact that there are some $100 stocks which may have a $20-30 intraday range and some $1 stocks on which you may actually be able to get away with a 1 cent stop loss).
3. Static Risk Amount:
The third school of thought on position sizing requires a lot more judgement on your behalf and will be more difficult for traders without a lot of experience and screen time. In this model you will attempt to keep your risk to a static amount (Say $100 or $200, or some percentage of your account value) on every trade by looking at the fluctuations in the chart and adjusting position size accordingly. For example, you might see a $100 stock and realize that you can’t get away with a 10 cent stop because the stock is expensive and seems to be fluctuating/oscillating 75 cents up and down, so in order to keep risk to $100 you buy only 50 shares and risk $2/share to make $6/share. On a cheaper stock, say a $1 stock that requires a five cent stop loss, you’ll buy 2000 shares in order to keep the same $100 risk.
The problem with this model of position sizing is that it requires you to be an accurate judge of just how far a stock can move which is inherently difficult to predict. It also gives you a false sense of security in terms of risk management because in a way it allows you to make a risky stock less risky. Consider a thinly bid $30-40 stock where the spread might be 20-30 cents. If you use a static position size or static share size it becomes very clear that this is a risky stock, but if you use a static risk amount it allows you to mask the true risk of the stock by buying fewer shares to account for the bigger fluctuation.
If you’re a newer trader, it’s easy to give yourself a false sense of security and make it seem “okay” to trade basically any stock if you just account for the extra risk with a smaller position size. This is ok if you’re experienced and have a track record of being able to accurately predict the fluctuations in various types of stocks, but for inexperienced and newer traders it’s more of a recipe for over trading where the majority of the trades will be low probability setups.
4. Variable Risk Amount:
The fourth and most complicated school of thought when it comes to position sizing is to use a variable risk amount (or percentage). Under this model, the idea is that you have a system of rules to gauge the quality and probability of the setup you’re trading, and based on whether it is an A+ setup, a B setup, a C setup, a D setup or an F setup (i.e. a gamble) you will risk a different amount. The highest risk will go to the highest probability and best quality setups.
For example if you have a setup that is very low risk (i.e. a very tightly coiled chart), very high probability (i.e. you’ve traded the same pattern 1,000 times and 800 of the trades were profitable), exists in the right market environment at the right time of day, and a host of other things you use to judge quality, you will call that an A+ setup and risk, for example, $500 on it.
On the other hand, if you have a setup where the pattern is nice but not super clean, the market is a bit shaky, you’re not really sure about the probability since you don’t have much data on this pattern, and the pattern manifests itself during the lunch hour when volatility dies down, you will call that a D setup and only risk $50 or $100 on it.
The problem with this, again, is that if you don’t have years of experience it’s very difficult to judge probability and quality. You really have to have tens of thousands of trades under your belt and have been through multiple market cycles to do this accurately. Also, why would you even want to trade a D or an F setup anyway? This risk model gives you an excuse to trade crappy setups! It also, like the third school of thought, has a tendency to allow your emotions to come into play and turn a truly risky play into something that appears to be low risk.
Personally I’ve always used the third method, and as I became more experienced I began using the fourth method. Lately I’m finding though that even though I have several years of experience now, I’m still not the greatest judge of just how far some stocks can move. Recently I traded AQXP from $19.93 to $22.03 on an intraday flag breakout, and simultaneously traded CALL from $8.45 to $8.55 on a HOD break. When I looked back at the trades at the end of the day I realized that the gains were exactly the same in terms of dollars, even though I made only 1.2% on CALL and I made 10.5% on AQXP! This alerted me that there is a problem: honestly, why am I trading a stock like AQXP if I’m not going to capitalize on the additional potential it provides?
The entire reason for taking on a more risky stock is to get a bigger reward, so it’s kind of pointless to trade both of these stocks using a static risk amount because I could make the same amount of money trading a much less stressful stock than AQXP. If I want the same amount of risk why not just trade a stock that I don’t have to babysit, a stock that doesn’t have a 50 cent spread, a stock that isn’t going to either spike $1 up or $1 down in the blink of an eye? Emotional capital is extremely important in trading and wasting emotional capital by trading risky stocks as if they’re not risky is just plain dumb.
This issue is what got me thinking about the four schools of thought on position sizing, and so lately I’ve started sizing my positions statically (i.e. using method 2) because it makes it very obvious to me when a stock is risky and I can consciously choose whether I want to take on more risk to reap a bigger reward, rather than trying to manipulate the risky nature of a risky stock and make it appear to be less risky by trading it with a smaller position size.
Which method do you like for you trading? Have you ever really thought about it? Hopefully reading this post has given you some insight that you can use to make your trading more selective and make your position sizes more comfortable for you.