The concepts of position sizing in trading and investing are arguably the most important in the journey to becoming consistent in performance. They concepts are not that sexy and the mathematics are trivial. Position sizing tends to be overlooked in the big ego game of stock selection and entry points.
When you have a great trading system such as VectorVest, it is certainly easier to meet your system objectives via a robust position sizing method. However, you still have a large chance to meet your objectives and profit with an average system or great system operated with poor discipline, if optimal position sizing is practiced.
There are many psychological biases which discourage the practice of optimal position sizing. In “Trading in the Zone”, the late Mark Douglas discusses the topic in some detail. In the book he writes about the concept of “thinking in probabilities”. If, using VectorVest, we can be correct in 80% of our trades then we are incorrect 20% of the time. On the next trade we simply don’t know whether it’s one of the 80 or one of the 20. The market cannot be predicted on a trade by trade basis. Over a batch of trades there is order but in a single trade anything can happen. As a trade/investor Mark’s book should be close and reread often.
If you think you know what’s going to happen next, on a trade by trade basis, then it’s easy to make a host of trading errors.
If you know what’s going to happen next, why place a stop loss?
If you know what’s going to happen next, why not put everything into that position? Let’s accelerate the process of wealth accumulation.
At VectorVest, we firmly believe in position sizing and its vital role in ensuring consistent performance. In lesson 2 of the Successful Investing Quick Start Course (SIQSC), this topic is discussed in detail and in the remainder of this post I wish to simply show how I have personally and simply managed this topic over the years. I will illustrate the calculation with a current example of a trade that may be about to setup. I have had many questions on the topic over the past few weeks and I hope this will clear them up.
Over the past three decades, I have been using a 1% risk model (or less) to define my position size. This does not mean that I only purchase shares to the value of 1% of my capital base but rather it is the amount of cash that I am prepared to risk to ascertain whether my trading idea is correct or not correct. The 1% refers to the cash lost if the share should fall from the purchase price to the stop loss figure. Let’s go through the calculations in detail step by step. Below is the chart of Hastings which I will use as an example.
- How much money is in your account? If you don’t know how much money is in your account, then you cannot size your positions, and if you cannot size your positions, then you are gambling and not trading or investing. I come across this all the time. The first step is to decide how much of your total capital you wish to allocate to your trading business. For the sake of this example I am going to assume that a new trader has 20000 pounds of capital to start their trading business.
- 1% of 20000 is 200pounds and this is maximum loss that should ever be taken on any single trade or investment. I know shares can gap through stops, so please don’t get your slide rule out. Losing 1.5% won’t kill you. It’s losing the lot, half or a quarter of the lot, that will kill you both financially and mentally.
- Hasting is still on a Hold on VectorVest but let’s assume that over the next few days and weeks it turns to a BUY. After due consideration, we decide to BUY the share at 325p.
- I use the VectorVest calculated stop and observe that the stop loss on the program is 300p. To make the sums easy, I will use a figure of 295 for the stop. This also then errs on the conservative side which is what the accountants call the concept of “prudence”.
- The Risk per Share is thus 325 minus 295 which is 30p and £0.3
- Number of shares to be purchased (N) *Risk per Share=1% Account Size.
- N=1% Account size/Risk per Share
- N=200/0.3= 666 shares
- Total purchase price = 666 *3.25= £2133
In many cases I start with a ½% risk model and then add to the position if my trading idea is correct. I have written about this in a blog post a few weeks ago.
There are many methods of position sizing and extremely complicated models are used by the institutional community and taught in financial management courses. I will write about these over the next few months. The disasters at both retail and institutional level are when no position sizing is practiced at all and the trader is sure that they know what’s going to happen next.
I hope the above will stimulate thought and get you thinking about how you will size your positions. There is a lot of discussion on the topic on the internet as a simple search will show.
In brief, divide your capital into 10 parts and only allocate 1 part to any single investment. Never have more than 2 parts focused on any single sector of the economy. Vow each evening before bed to NEVER lose more than 10% of each part.
As traders, it’s our job to focus on perfect execution of each trade without fear or hesitation. Sizing the position correctly in relation to the size of our account whilst using a sensible stop loss is a big part of the execution process. A part of the process which is frequently overlooked. As a result, most of the failures in trading don’t stem from poor analysis but rather from poor or non-existent position sizing.
Please let me know if this has helped.
September 2nd 2017