Position Sizing – What is it and How to Apply it?

Position sizing is about deciding just how many shares to buy or sell and it is crucial to Money Management (as is setting a Stop Loss). I consider determining how much to buy or sell the single most important aspect of trading because using a position sizing strategy limits your risk which in turn gives greater confidence to enter the trade.

I have found that most traders conduct each trade with the exact same position size, e.g. they invest $10,000 into each trade. If you are a trader that fits into this category, hopefully this article will cause you to adapt your trading strategy – or cause you to develop one.

Determining Position Sizing

The first thing you need to do before determining your position size is to identify your maximum level of risk, i.e. how much money are you prepared to lose on a trade before you will exit the trade.

For the purpose of this article, I will demonstrate what I do. Many other traders do differently to this but this works for me. I have a trading account of $200,000 and each of my initial* trades will use no more than $15,000 of this $200,000. This allows me to have a minimum of 13-14 trades running at one time (diversification). I am prepared to lose $1,000 per trade before I will exit the trade. Before entering a trade, I need to know what the Average True Range (ATR) is for the stock I am trading (ATR is discussed in my third article that I posted on the 24/5/09).

I will now site an actual trade that could have been conducted by referring to the below chart.

Chart supplied by http://www.incrediblecharts.com/

On the 17 March 2009 you could have bought DJS at a price of $2.46 at the open. The 14-day Average True Range on this date was $0.11 (to the nearest cent). I use a stop loss of 2 ATR therefore, my stop loss for this trade would have been at $2.24 which is $0.22 below the entry price.

$2.46 – (2 x $0.11) = $2.24

Divide the amount that I am prepared to lose ($1,000) by 2 ATR ($0.22). This gives me the amount of shares I would purchase at $2.46 (4545 shares).

$1000 / $0.22 = 4545 (rounded to the nearest whole amount)

Therefore, on the 17 March, 2009 4545 DJS shares were purchased @ $2.46 for a total cost of $11,180.70. The stop loss is set at $2.24. If the stop loss is reached, I would sell:

4545 shares x $2.24 = $10,180.80

$11,180.70 - $10,180.80 = $999.90 which is the maximum I could lose from this trade.

As you can see in the chart above, the stop loss was not reached and I would fall back on my exit strategies to exit this trade. For interest’s sake, if you were still in this trade at time of writing you would be sitting on a nice paper profit of $5,181.30 as DJS closed at $3.60 on Wednesday the 27 May, 2009.

I do not factor in broker costs or slippage when I do my calculations. The reason for this is that broker costs are insignificant in comparison to the amount of the trade (as I trade CFDs my broker costs do not exceed $40 for the entire trade). Slippage very rarely occurs and I quite often get out of a bad trade before the stop loss is activated as other trading tools such as certain technical indicators have indicated to me that the trade is going bad before the price has reached my stop loss. As a result, my maximum loss can end up being less than the $1,000 limit I set myself.

*I referred to initial trade as this example doesn’t include anything on ‘adding to my position’ which I will discuss in another article.