Position Sizing principles for monster performance
central dogma of a trade 4.2
Hello Traders,
Last week we discussed Risk Management and continuing the discussion, we will discuss its sister concept i.e Position Sizing.
What is Position Sizing?
Position sizing is a crucial aspect of successful trading, whether you are a beginner or an experienced trader.
Position sizing refers to the science of determination of how much capital to risk on any given trade. In other words, it's the process of deciding the size of the position you want to take on a trade.
Why is Position Sizing Necessary?
Position sizing is necessary because it helps you avoid the “risk of ruin”.
The risk of ruin is the probability that an individual will lose substantial amounts of money through investing, trading, or gambling—to the point where it is no longer possible to recover the losses.
Position sizing helps you manage risk. Every trade carries some risk that is impossible to predict. By sizing positions appropriately, you can limit potential losses and maximize your gains.
For example, If you put all of your capital into a single stock or trade and the trade goes against you, you could lose a significant portion of your capital. However, if you properly size the position according to your risk appetite, you could limit the potential loss and preserve capital for future trade.
Another reason position sizing is necessary is that it helps to manage your emotions better. Emotions such as fear and greed can cloud judgment and lead to poor decision-making. By setting a predetermined position size (and a maximum risk per trade), you can remove some of the emotional elements from the decision-making process.
Having a smaller risk which is under your risk appetite will basically help you sleep better.
Sound Position Sizing Principles:
Do not risk more than 2% (1% if you are a beginner) of your PF on a single trade.
The amount of capital allocated to a position should be determined by the level of risk associated with that position. A general rule of thumb is to never risk more than 2% of your account on a single trade. You dramatically decrease the Risk of Ruin by doing this. You can have a series of 10 losing trades (which is unlikely) and still will only be down by less than -20% on your PF.
Diversification:
Diversification is another important principle of position sizing. By spreading your capital across multiple investments or trades, you can reduce the overall risk on your portfolio. It is generally recommended to have no more than 5-10% of your capital in any one trade as a beginner (Once you reach a pro level, you can size it up, ~25-50% while managing risk at all times).
I should also caution you against over-diversification. Mathematically, having more than 16 positions adds no benefit to diversification but rather dilutes the success of any one trade on your PF.
The range I like is between 5-10 positions. This allows each of my trades to have the potential to move my PF meaningfully while also having a negligible risk to my total PF amount.
Do not put more than 25% of your PF into a single trade:
For your total risk to be less than 2% for a trade with 25% of your PF, the initial stop loss has to be at least 8%. Anything below 8% for an O’Neil-style breakout trading increases the risk of your SL getting hit. Therefore, it is advisable to build your position with under 25% of PF. You can always increase the size as the trade works in your favor (a topic for next week’s article).
Market Awareness: Trade small size in a sideways/volatile market and trade big size in bullish markets.
Market conditions can greatly influence the size of your position. In volatile markets, it's important to reduce your position size to manage risk. In contrast, in less volatile markets, you may be able to take larger positions.
Similarly, if you are still going long in a sideways/down trending market further reduce your risk per trade.
On similar lines, you can also decrease your size in a losing streak and increase it as your winners pile up (which mostly happens during a bull market)
Being said that, One should also have a minimum size added to a position to move the portfolio. A winning trade without adequate size is of no use. I try to have at least 5% as my minimum size in any entry (this is halved when I have a losing streak or the market is in a clear downtrend).
In conclusion, position sizing is an important aspect of successful trading. By following these sound principles, you can manage your risk, maintain consistency, and increase your chances of success. Remember to always stay within your risk management parameters and stick to your trading plan.
That’s all for this weekend.
Next weekend, I will discuss 2 different ways to position size a trade, i.e whether to enter with a 100% position or to average up incrementally and how?
See you soon
~ Prakash (SH)
Here is the last week’s article on, “How to manage risk like a pro?”
https://sakatas.substack.com/publish/post/100785681
Your blogs are very informative. Thanks for sharing your knowledge.