HOW TO… DETERMINE THE SIZE OF A POSITION?
You have spotted a great stock and you want to buy. You are
in front of the ideal trading set-up and you are decided to pull the trigger…but
how many shares?
Position sizing is one of the most overlooked subjects in
trading and investing, and yet on the long run it determines a good part of the
overall profitability.
Why is a good position sizing method important?
- It gives each trade the same weight in your portfolio, or allows you controlling these weights rigorously
- It ensures that you do not take an outsized risk on a given trade
- It ensures that you won’t go in a trade with a ridiculously small stake
- Controlling the risk at a constant percentage of capital maximizes the odds of growing it. It is the famous “Kelly formula”.
Define the size of the position in 4 simple steps.
Let’s say you want to buy stock XYZ at $15:
STEP 1: Take your total capital you want to use for investing or
trading and decide the percentage of this capital you are ready to “bet” (to
put at risk) on a given operation/trade. This percentage is typically set
between 0.5% and 2%. Normally this percentage is the same for all trades.
For example you have a $10,000 capital; you decide
that your risk will be 2% or $200 (2% of $10,000).
STEP 2: Decide where you are going to place the stop-loss
order (see: How to…place a stop-loss order). You apply what you learnt and you
set the stop-loss at $14.2.
STEP 3: Compute the possible loss per share: if the trade
goes bad, your stop-loss will be hit and you will lose 15-14.2=$0.8 per share
STEP 4: The number of shares that you can buy while
respecting the amount of risk equal to 2% of capital is simply derived from
200/0.8=250.
That’s it. You buy 250 shares of XYZ at $15 with a stop-loss
at $14.2 and you already did a good job: applying a strict methodology is the
first success in trading and investing.
