Position Sizing 101

There’s an often overlooked aspect to risk management and it’s the big brother of stop losses known as position sizing. A thorough understanding of this concept provides another useful tool in every trader’s toolbox. I’ll start by saying this piece is most helpful to the position traders and a completely different set of rules is appropriate for the day and swing traders. Additionally, a quick word on stops… if you want to take a quick seat on the sidelines, place your hard stop along with everyone else’s AT the pivot, obvious support or right on the 10/20/50ma, etc. On a weak open or come lunchtime, while volume is hunted, those stops will likely get tagged. Often seeing price reverse higher shortly after and frustration ensues. Ideally, if your position is sized correctly, one should be able to place their stop comfortably below obvious support levels and maintain a proper risk management profile.

I happen to be in the 1-2% risk camp. Meaning I’m willing to risk 1-2% of my total portfolio as a maximum loss on each stock idea. Before I take a position, I’m going to look at the risk involved and see how that would be reflected on the chart. A small cap, low float, high flyer breaking out of a bull flag is going to have a different approach than if I’m buying AAPL coming out of a base. Think about this… pick any small cap biotech as an example. If I put 20% of my portfolio in PRQR, my stop needs to be within 5% if I want to maintain my risk profile at 1%. Not a very wise idea with a stock that has a float of 30M and an ATR of 8%. However, if I take a 5% position size, my stop loss can be up to 20% below and I’m still risking the same 1% of my portfolio. This is an extreme example for effect and does not replace chart support/resistance, which still needs to be noted and respected, but is another way to think about managing risk and differentiating your stop placement from the crowd…

Take a look at this example with CGC. If you bought the breakout above 56.60 on Monday, you’re likely already stopped out. Knowing the big legalization day was on Wednesday and volatility was likely to be elevated ahead of the event, one could’ve expected action to be wild last week. So even with a 10% position size and larger than 10% stop, the breakout traders should’ve been taken out above 50 and still escaped within the 1-2% portfolio loss range. Moving on… the channel (blue lines) has contained all closing prices back to mid-August. So lets assume you bought the close on Friday for 46.85 and support comes in just above 46 in the form of the rising channel and 50ma. Think about how you can size this position since your stop can be super tight. One can place a stop below Friday’s low and be within 2%. This is an especially important concept for those of you that have a smaller account size (under $20k). These are the type of risk/reward profiles you’ll want to identify and can trade very aggressively… up to 50% of portfolio size can be risked here and still maintain a 1% total portfolio risk on the trade… 50%! Larger accounts can come in at 20-25% size and still risk < .5% of AUM when the stop is this tight. I know there can be slippage on a gap down and this is a volatile group but, in general, these are the risk/reward profiles that one wants to take advantage of. Maybe it works, maybe it doesn’t… there are many other factors in play here that need to be evaluated, but the risk management side of this discussion is what I want the focus to be on. Don’t shoot the messenger because of the stock choice for the example! 🙂

Most importantly, what the new trader wants to avoid at all costs is buying the breakout at 30%+ position size and letting price come all the way back to support 20% lower and you’re now down 6% portfolio value on one idea. Using margin? Ok, double that. Support fails? Ouch, an even bigger loss. That’s where the new trader really gets in trouble. In summary, size positions to maintain the 1-2% max portfolio loss while simultaneously allowing your stop loss to be placed BELOW obvious support. The tighter the stop, the larger the position size can be and higher reward if you’re right… this is ideal. The wider the stop, the smaller the position size should be to maintain proper risk management and still give the trade enough room to work, especially on the most volatile stocks (looking at you biotech traders). As mentioned, account size plays a very important role, too. Proper position sizing is another weapon that needs to be in your arsenal and it’s an especially important concept for position traders.

Update: great formula for proper position sizing courtesy of @schwabtrader on twitter… total $ risk/stop loss amt = # shares to purchase. Hat tip and a great follow! In this example, if you’re account is $100k, you can risk $1000 (1%) on an idea. With a theoretical $5 stop, the correct position size is 200 shares.

Disclaimer: None of the presented content represents individual investment advice to buy or sell securities and the information provided is solely for informational, educational and entertainment purposes. Author is long CGC at the time of this writing.

2 Comments

  1. Great post Ben. This is a really important topic. I like to use this formula:
    Total $ risk / stop loss amt = # shares.to buy.

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