The Most Important Aspect Of Money Management - Position Sizing

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When we talk about position sizing, we’re asking the question, “How much are we going to put into any one trade?

Fortunately, by adopting the two percent rule we talked about earlier, we’re using a strategy that decreases the size of our losses during losing streaks. When experiencing a winning streak, our position sizing will actually grow. What’s more, by simply changing the amount of capital we’re wishing to risk, we’re going to change the characteristics to our risk to reward ratio.

Many people believe though, they’re doing an adequate job of position sizing by simply having a stop loss in place. Sure, this will tell us when to get out and by setting our maximum loss, we’ll also know how much capital we’re risking, however, it doesn’t answer the question of how much or how many units we can buy, hence it is poor position sizing. Again, since we’ve already calculated our maximum loss and our stop loss, we can simply take these values, plug them into a formula and calculate how many shares we purchase without ever exceeding our maximum loss.

Although very simple, this formula for position sizing I’m about to give you is extremely powerful. The position sizing formula goes like this – the number of shares is equal to our maximum loss divided by our stop loss size. You’re already familiar with what our maximum loss is, I just need to define what a stop loss size is. It’s the difference between our entry price and our stop loss value. So, if we go back to our example earlier where we were talking about entering a stock at one dollar and setting our stop loss at 90 cents, the stop loss value is the difference between our entry price and our stock price or ten cents.

It’s just a matter of plugging the values into the position sizing formula, and it will calculate how many shares you should buy so you never risk more than your maximum loss. Now, for those of you who don’t like math, you don’t need to worry because I’ve made this as easy as possible for you. Included in this package, you would have also received a money management calculator to help you figure out your position sizing. So, now all you need to do is plug in the values into this calculator and you’ll have set excellent money management every time.

Let’s now look at how this position sizing formula works in practice. If our trading float was 20,000 dollars, and we were risking two percent, our maximum loss would be 400 dollars. If our entry price was one dollar, our stop loss value was 90 cents, our stop size would be ten cents. Now, to use the position sizing formula, the number of shares is equal to our maximum loss divided by our stop size. We calculate that we can purchase 4,000 shares. If this stock reaches our stop loss, and we have to exit the trade, we know we’re not going to risk or lose more than two percent of our float, which is 400 dollars.

This position sizing formula is extremely simple, but also extremely powerful. Another little finesse point that some of my clients like to include is to class brokerage as part of the maximum loss. So, how would you go about doing that? Well, if brokerage were 40 dollars for our return trip, we’d subtract 40 dollars from our maximum loss. So, instead of entering our maximum loss as 400 dollars into the position sizing formula, we’d now enter 360. Once this is computed out, we can determine how many shares we’d buy, and we know that we are including brokerage as part of our maximum loss. There’s one small caveat that you need to be aware of when using this formula to calculate how many shares you are going to buy.

The astute listener may have realized how many shares we can purchase is determined by our maximum loss and also the size of our stop. So, by increasing our risk, we can also increase the dollar value of the position sizing, or by simply shrinking our stop size, that is setting a tighter stop loss, we can increase the dollar value of the position sizing we open.

So, to avoid this situation where we open excessively large positions that might put our trading float at risk, you may also introduce an extra rule that limits the dollar value of a position sizing to be no more than a set percentage of your entire trading float.

For example, you might say you’ll never open a position sizing that has a dollar value of more than 25 percent of your entire trading float. This rule would only ever get executed if after calculating the formula that determines how many shares you buy, you find the dollar value of that position sizing would be an excessively large position and greater than 25 percent of your trading float. If this was the case, all you would do is simply scale down the position sizing to make sure it never exceeds that 25 percent.

Now, the percentage value that you decide to choose will depend on the type of system you’re trading, the size of your float, and also your personal tolerance for risk. As a guide though, smaller trading floats might use 25 percent, whereas larger trading floats might use as little as 10 percent or even five percent.

There are no definitive answers and it will depend on your personal circumstances. This leads on to my next point that your study of money management shouldn’t stop with just listening to this course on position sizing. You need to take the principles that you learn in this course, realize that I have simply set up the goal posts for you to shoot between. You need to test your system to find out which of the variables best suit you, and remember position sizing is the most significant part of any system design. It is the central theme of money management. Be sure to take what you’ve learned here and apply it in your system.

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