SIZE DOES MATTER

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.

hast

  1. 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.
  2. 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.
  3. 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.
  4. 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”.
  5. The Risk per Share is thus 325 minus 295 which is 30p and £0.3
  6. Number of shares to be purchased (N) *Risk per Share=1% Account Size.
  7. N=1% Account size/Risk per Share
  8. N=200/0.3= 666 shares
  9. 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.

 

David Paul

September 2nd 2017

22 thoughts on “SIZE DOES MATTER

  1. Hi David Yes its very helpful.It lets you know the most you can lose is 1% if things go wrong.And the 1/2% start is a good idea adding the other 1/2% when the stop loss rises to your entry point of £3.25.

    1. Well done …adding is the secret …small when you are wrong ….big when you are right…easy to say and write but more difficult to do good trading david

  2. Interesting article, David!

    I have a mix of EFFs and Investment Trusts in ‘pot one’, and Ordinary Shares in ‘pot 2’.

    The ETFs and Investments Trusts in ‘pot one’ are all working with an automated stop loss which is the VV daily close stop-loss figure (Smallest Stop Loss -4.9% [USDV.L], Largest Stop-Loss -10.3% [XSPR.L]). The Ordinary Shares in ‘pot 2’ have their stop loss calculated from: VV daily close stop loss minus 2.5% (‘safety’) minus the Bid-Offer Spread (which varies according to each share’s liquidity). Smallest Stop Loss is -7.4% [BOO.L], Largest Stop Loss -22.5% [KAZ.L].

    The answer is that each of the 23 holdings is well within their 1% size limit (maximum 0.5%, minimum 0.11%).

    Adding just two columns to my spreadsheet tells me that I have – in the past – trimmed winning positions slightly too soon. I was also surprised that my largest potential loss was actually an ETF (HMCH.L) that had had a strong run – I had assumed that it would have been an ordinary share (KAZ.L).

    My total portfolio level risk is 6.5% with a cash level of 15%.

    N.

    1. Hi …I am glad the article has stimulated interest. You seem to be well on top of the subject and that’s great. Good trading to you david

  3. Hi David,

    Everything you say is very prudent, and I appreciate that you are talking to a wide audience, with varying ranges of experience. However I would just add that sticking to 2 parts in a single sector may restrict your profits.
    A rising sector seems to keep rising for longer than we think. By taking a little more risk into buying a couple more stocks in rising sectors, this is often offset by the larger gains made, in my limited experience.
    I might add that I do watch the sectors on a weekly basis.

    1. Hi Bill Thanks for the comments. I am being prudent I know …In 2013/14 the only sector rising was construction/building and I was vastly overweight these stocks and got away with it …Looking forward to meeting up in Edinburgh before the end of the year probably in November trade well david

  4. Yes 1% stop loss is well discipline trading practise. If the odds are against us maximum you loose is already predicted .what about getting the profit. How to avoid not to give it back to the market. May be a tailing stop or take the profit and run away.

  5. Hi David,
    Thanks for this article. I have been using a £3000 investment size for all my trades to keep dealing costs down and have got away with it in most cases. I now see the need to be more precise and will be using this method in the future. This will make for smaller initial purchases and more stocks to spread the risk over. I can always add to the positions at later dates as the stock is ‘proved’.

  6. Great article David

    I have always used a size of 10% or just less – even before finding VV some 5 years ago. Using your calculations on shares I am currently interested in 1% loss/risk ratio gives between 9% and 11% of my pot. [I use three search methods based on your lectures to users groups and on line with a few variants of my own]. I need at least two of the searches to give a share before I consider it and then use TA: to determine entry.

    However if I look at other shares where the share price is close to the stop [not necessarily complying with my criteria] I end up with a size of more than 50% of my pot. If I look at a share with a wide margin between price and stop then the size drops to a level below which I am willing to purchase.

    My pot has recently been added to quite substantially. Even using 0.5% the level is beginning to terrify me. Secondly even some 250 companies have normal trading size 20%/30% of the size the calculation shows I should trade. Thirdly Jim Slater [the first guru I followed 30 + years ago] said no one can follow more than 20 shares at one time. I think David you say much the same.

    I am in a bit of a quandary !! Any suggestions?
    I am aware that some VV users have pots of 7 figures [Mine is much much lower]. How does one trade at that level?

  7. Excellent advice as always David.
    I have copied in a part of a presentation I prepared for a user group meeting.
    I hope it might add to the discussion.

    The first 3 lines I always have printed on my desk and trade plans and may act as an aid memoire to others.

    Trade what you SEE, NOT what you think!!!!!!!

    The simplest advice can sometimes be the most valuable.

    Complexity can sometimes cause mindfreeze. Keep it simple.

    Portfolio % values for stop distances to ensure a maximum loss of just 1% according to the number of stocks in your portfolio. This assumes equal cash weighting per position.

    At the extremes to demonstrate….If you have a 1 stock portfolio, that stock holds 100% of your investment so you can only have a 1% loss on that one stock to stay at a 1% loss.

    A 100 stock portfolio can lose 100% of each position and still just lose 1% of the overall portfolio.

    So, in between..

    A 10 position portfolio will hold 10% of the overall value in each position so can lose 10% ( one tenth of that position) to have a total loss of 1% portfolio value.

    A 20 position portfolio will hold 5% of the overall value in each position so can lose 20% ( one fifth of that position ) of it’s value to have a total loss of 1% portfolio value.

    A 5 position portfolio will hold 20% of the overall value so can lose 5% ( one 20 th of it’s position) of its value

    So assuming a £100,000 portfolio for easy calculation £1,000 is your 1%

    20 stocks. Holds 5% of portfolio in Each posn 1/5 = 20% stop-= 1% =£1,000
    10 stocks. Holds 10% of portfolio in Each posn 1/10 = 10% stop-=1% =£1.000
    5 stocks. Holds 20% of portfolio in Each posn 1/20 = 5% stop-=1% =£1,000
    1 stock. Holds 100% of portfolio in Each posn 1/100 = 1% stop-= 1% =£1,000

    15 stocks Holds 6.66% of portfolio in Each posn 15%stop-= 1%

    15 stocks with a 25%stop-= 1.8% loss

    To look at it from the other direction…and easy to remember…

    A 5 stock portfolio should only lose 5% of each position value
    A 10 stock portfolio should only lose 10% of each position value.
    A 15 stock portfolio should only lose 15% of each position value.
    A 20 stock portfolio should only lose 20% of each position value.

    The more positions held the larger your stop loss as a % of each position size can be.

    Just grab a calculator pen and paper and spend a few minutes with it. It might look long winded but will soon become clear.

    Good trading everyone.

    1. Hi Mark,
      You say ‘A 100 stock portfolio can lose 100% of each position and still just lose 1% of the overall portfolio’. Did you mean:
      ‘A 100 stock portfolio can lose 100% in ONE position and still just lose 1% of the overall portfolio’.?

      Regards
      Frank

  8. Hi to all,
    Just to add to my last comments…
    Cash is a position.
    If your trade plan says hold 10 positions and you only are holding for instance 7, then you should still do the calculations as if you were holding 10.
    You might fill 3 more tomorrow.

    M. C.

    1. Hi Mark Good point and I think you have answered it yourself. Just another line in your trading plan best wishes david PS hope you and family are well and have recovered

  9. Informative and thought provoking
    Courtney smith taught me the pyramid principle
    which could be incorporated in the position sizing
    discussion
    Andrew

  10. Another excellent article by DP and very clearly expressed.

    The Achilles heel of all of this are those days when you switch on your PC and EVERYTHING is red….all over the world…. the same percentage down everywhere, as if there was collusion!
    IF you are unlucky you could lose 10% on EVERY stock you have and therefore 10% of your total portfolio!!
    Been there….NEARLY got the T shirt! 🙂
    Frank

    Frank

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