Editor's note: We've dusted off this April 14, 2015, article because its focus on position sizing is as important as ever. That's particularly true as traders get busy with the holidays, and as markets continue to reflect the influence of Federal Reserve decision-making and global economic instability. Will it be the season for stock outperformance? It's always the season for unexpected market turns that could exploit traders who've taken on more than they can handle. With that in mind, brush up with this position size primer.
So, you’ve done your analysis, stalked the perfect entry point, and are about to execute your trade. But first, you have to answer the most critical question in determining your risk vs. reward: How many shares should you trade?
If you are like most investors, you’ll tend to choose a number of shares in multiples of 100. That’s because we’re naturally drawn to round numbers. Unfortunately, whether that number is 100, 500, or 1,000, it’s often arbitrary, with no relation to your risk profile.
But there’s a simple way to determine the optimal position sizing for any type of trade—one that fits your risk profile and helps you feel comfortable with your trade no matter what the market is doing.
Let’s start by determining how much risk you’re willing to take on.
Many good traders will tell you that before they enter a trade they already know where they will set their stop loss. This number is usually chart-based, determined by objective technical criteria. So to identify your ideal position size, first determine the difference between your entry price and the price at which you want to apply the brakes.
For example, if you plan to enter a trade at $25 and with a potential target of $28.00—based on an overhead resistance level—and have a pre-determined stop loss of $24.00, you are theoretically risking $1.00 on the trade. Now, keep in mind, the stop-loss will simply trigger an order at that target price; the open market still determines at what price the trade is filled and that could be a price above or below the $24 trigger price.
Next, determine how much total portfolio risk—in dollars—you are willing to take on any given trade. This amount should not be so large as to significantly hurt your account equity or make you feel uncomfortable. A good baseline to start with is half of one percent—0.5%—of your total trading capital. So, if your account value is $50,000, your portfolio risk is $250.
Now, take that $250 portfolio risk and divide it by the $1.00 theoretical trade risk from the previous example, which comes out to 250. This is the number of shares you will use to size your position. And because the number of shares is no longer arbitrary, but specifically designed to fit within your risk profile, even if your stop loss is hit, the maximum you will theoretically lose is your portfolio risk of $250.
You could then enter the trade and set up an OCO order (one-cancels-other), which combines a stop order at $24.00 and a limit order at $28.00, either of which cancels if the other is hit. This automatically limits your loss and will lock in your profit if the target is reached.
This method is based on your overall account size, which gives you the added benefit of automatically scaling your positions up or down based on performance. If you are doing well in the market, your position sizing will grow along with your account equity. That’s what you want. By contrast, if you are underperforming in the market and your account equity is dropping, your position sizing will decrease, putting less money at risk.
This method is also flexible and works well with different trading styles. If you are more aggressive, you can raise the portfolio risk to 1% of your account equity. Risk averse? Take it down to a quarter of a percent.
Either way, you are sizing your positions in a way that makes sense and works with your risk tolerance.
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