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Position sizing balances Opportunity Management with Risk Management.
Opportunity Management is how you distribute money to take advantage of all
the current opportunities and potential future opportunities. If you are
100% invested all the time then what will you do when a new
excellent opportunity presents itself? You have no bullets left.
You need to reduce your portfolio size when storm clouds are
gathering to reduce your hit if the storm passes over your
positions. If you
are under invested (too much cash) then your overall performance will suffer.
Selling half your positions is a good alternative to selling
everything when the risk of a pullback is high but there is no
sign yet of it actually occurring. If you have good field
position in a nice bear market, you should not fold up and run
on the least little scare. Otherwise you will often finding
yourself buying back you positions at higher prices. That is the
fallacy of picking tops and bottoms: for every real top and
bottom you pick, you will have four or five false alarms. Hold
your field position unless your have good technical reasons to
exit.
How much risk should you take with one position? The answer changes with the size of your account and your need for the money. These answers
will establish
you risk profile.
Needing the money for income creates pressures in opposite directions: More aggressive trading means more income but also more risk of losing your income.
If your account size is a bit too small then you need to work it harder (i.e. take more risk). The risk level you will need is probably too high and you will suffer a setback with too much risk on.
Live small when your account is small and live big when your
account is big.
The younger you are, the more risk you can take and still recover for another try. But there is no use throwing away a good start with too much greed. As
a trader you need to approach trading like a business. To be a successful startup business you need to be willing to sacrifice personal luxury in the
short run for the health of the business in the long run. Preservation of capital must be number one if you plan to be a successful trader.
Balancing risk and reward is an important consideration in choosing a trade. If the next major resistance level is two points up and the next major support
level is one point down, then you have a 2:1 risk/reward ratio. You should never enter a trade with less than a 1:1 R/R ratio. If you don't know what your
R/R ratio is then you probably shouldn't enter the trade. If you can maintain a 2:1 or better R/R ratio then you can be very successful with only a 50% win/loss
record since your winners make so much more than your losers.
Too much risk is the biggest mistake new traders make and is the most efficient way to zero out your account. See our Risk Management article. How much
risk is the right amount? It depends on a great many factors: 1) Your win/loss ratio, 2) Your average loser vs. average winner size,
3) your overnight risk
(higher for Forex and commodities), 4) the beta of the stock to
the overall market, 5) the average daily range, and more. If you have sizeable winners and small losers, then you can take on larger size. If your win/loss rate is above 60%
then you can take on more risk. New traders usually take very large risks before they even know if they are a good trader.
The amount of risk you take on a trade is never determined by how much money you plan to make on it. You need to look at how much you might lose in the context
of the possibility of multiple sequential losers. For example: If a stock is selling for $25 and you plan to make 2 points on a trade and you want to make $1,000
on those 2 points then you will need to go in with 500 shares. However, 500 shares is $12,500. If your account size is $8,000 then you will be margined up too high
and a $500 LOSS (assuming 1:1 R/R) would be an excessive loss. It would be better to shoot for a $200 gain/loss or plan to use a tighter (stop if it is possible to do so).
We have seen traders lose their entire account plus another $20,000 on a single bad trade due to excessive risk.
The safest way to approach position sizing is to start TOO SMALL and then gradually work your risk up over a period of many months. You should set aside
some reserve cash as you approach higher levels of risk. Always go for the trades that present the best risk/reward opportunity and never less than 1:1 risk/reward.
Do not cry over missed opportunities. Missed opportunities are easier to make up for than lost money. There is always another trade and you will need
thousands of additional profitable trades to make a living at
this business.
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