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Just the Right Size: How Position Sizing Can Save Your Neck

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May 5, 2013
Trading Sized Right

There it sits. That stack of crisp bills you hope to grow with well-placed and well-timed trades. Sure, most accounts are virtual, but at the end of the day the money is real. Picture it in a tidy row. It may help you think about how best to divvy up your starting dough to trade efficiently, effectively, and within your risk parameters. You might ask: should I earmark the same amount for every strategy, or even every trade within that strategy? How many trades should I juggle at one time?

All great questions, and while there’s no perfect answer, there are some basic guidelines that may help you size your trades to fit your plan. The best part? Should your account start to strain at its seams, you can always alter that plan and rethink your risk management. The point is you should care about trade size at the outset and all the while you implement your strategy.

For now, start here:

Identify And Set Your Max

Whether you trade stocks, options, or both, the definition of risk capital isn’t always clear. For example, if you own 100 shares of a $50 stock, you might assume that your risk capital is $5,000. But what if you bought the stock at $25? You might calculate your risk capital from $25 per share instead. Or, what if the shares were a gift that didn’t cost you a dime? These questions beg for some definition of risk capital. Some traders opt to follow a simple thesis—risk capital is the amount of money that you can realistically expect to lose if nothing goes according to plan.

The beauty of this definition is that it doesn’t matter how or when you got your assets, it assumes their current value as the starting point. Then, you may apply any of the handful of percentage guidelines (rules of thumb, really) tossed around at trading seminars and in chat rooms that leave you most comfortable. For options, for example, one such rule limits the slice to no more than 5% of your total portfolio per trade. If you follow this rule, a $10,000 portfolio means that each option trade should not top $500.

By dedicating a small amount to each trade, you’re not likely to become overly attached to any one position, which can help you leave your emotions out of trading decisions. And, 5% is generally thought of as a small enough allocation that you can diversify the remainder across markets, strategies, or timeframes. You theoretically reduce your chance of losing all your money to a single market event.

Consider The Cost Of Doing Business

Does this mean you should spend your $500 allowance any way you want? Probably not. Think about it. Does the purchase of one $10 call option (the right but not the obligation to buy the underlying security at a set time and price) have the same risk profile as the purchase of 100 out-of-the- money butterfly spreads for 10 cents? Technically, both trades require $1000 of risk capital. However, the butterfly (a three-legged option spread, or multi-part directional options strategy using three options contracts with equidistant strike prices for the same underlying that has limited risk and limited profit potential) may cost you more in brokerage commissions and fees than the single option trade. This should affect your assessment of the trade because depending on the specific transaction, commissions paid may exceed your risk capital.

As you start out, you may want to set a maximum number of contracts; one oft-quoted beginner’s rule of thumb sets the max at 10 stock trades. Your first option trades should probably start with a single contract. Once you have a handle on how trading feels, you can slowly increase your trading size as you feel comfortable. It’s an additional safeguard that might limit you from impulsively loading up on trades that may be too good to be true.

Only What You Can Remember

Who wants sticky notes littering their monitor and their mind? Another common rule of thumb is to start by holding only as many positions as you can remember. That’s right. Initially, this may mean holding a single position.

Then, the more you trade, the better your trade memory will become and the more positions you’ll feel comfortable adding. So, if you allot 5% of your total capital to each trade, you may feel comfortable in the ballpark of up to 20 trades in place simultaneously.

Leave Room For Dessert

There are times you’ll want to increase your position size. This means that you might want to keep some of your account in cash, some guidelines call for between 10% and 20%.

You never know when an opportunity crops up. It can be less costly and certainly more convenient to have cash readily available than to have to liquidate one position to initiate another.

As such, you may want to increase the amount of funds that you dedicate to options. If you originally dedicated 10% of your investment portfolio to options, you may decide to bump that to 12% or more. And while you’re at it, you may decide to branch out from basic, single-option trades such as long calls and long puts into more complex strategies. Finally, changes in market conditions and in overall trends may alter the lifespan of your average trade.

Most of us aren’t in the same size we wore in high school. We adjusted. Likewise, it’s wise to revisit your trading plan from time to time to secure the right fit. But ultimately it’s up to you and your level of comfort and risk tolerance.

Personal Attention

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