Reinforce Position Sizing

All traders and investors must learn position sizing so they don’t run the risk of ruin.
I have decided to post what I was writing on a forum recently after someone asked a few questions about diversification and the number of positions one should hold.

Traders should never risk more than 1% or 2% per trade. Some traders I know start by risking 5% of their account but will lower the risk after each successive loss. For example, they will drop the risk to 4% after a loss, then 3% if another loss occurs and so on until they are risking very little during a long term losing streak. I don’t trade this way but it may be a preference for some of you.

How do we Calculate Position Size?
We can determine how much to place on each trade by assuming a $100,000 account with 1% risk on each position. Using a basic trading approach (for example purposes only), we will place stops approximately 8% below the ideal entry area or pivot point. Please use more advanced methods for locating the ideal stop rather than a general 8% rule. Look for the ideal risk-to-reward setup based on recent support and resistance levels and set your stop and potential target accordingly.

Use and Download the Position Size Calculator I created in Excel.

$100,000 Account
1% Risk = $1,000
8% Stop Loss
Position Size will be $12,500
We calculate the position size by dividing the 1% risk by the 8% stop loss or $1000 / 8% = $12,500.

If the stock we are watching has an ideal entry of $50, we now know that we can buy 250 shares or $12,500 worth of stock. Our stop loss is $46 or 8% of $50 and our maximum loss is $1,000 of the original $100,000 portfolio.

So, why can’t we risk more per trade and obtain greater rewards?

Think about it: Even the best systems can and will have losing streaks of 10 or more (not often but it can happen). Historical testing shows us that profitable systems can and have lost 20 times in a row. If you are risking 5% or more without proper position sizing: YOU WILL BE TOAST! CLOSE TO DONE! Very hard to come back!

Fortunately, my longest losing streak ever was eight but I don’t day trade so my opportunity for longer losing streaks has been held in check. But, I have only been trading for 10 years so will assume that I will extend that streak one day (it’s the way the market works).

***EXAMPLES BELOW ARE SIMPLE AND THEORETICAL SO EVERYONE CAN FOLLOW FOR EDUCATIONAL PURPOSES ONLY***

• At 1% risk (good for accounts above six figures), it would take hundreds of losing trades to bring on ruin. You will risk 1% of total equity, not the $100,000. So, if you lose ten consecutive trades, you will still have approximately $90,000 minus slippage, trading fees and other commissions, etc… So at $90,000, your risk is now $900 maximum!
• Using 5% risk, your account will be below $60,000 capital from $100,000 after 10 consecutive losses. You now need to trade and make back 65% on your money to break even. Do you make 65% a year in the market now? Most people don’t.
• Ten losses at 1%; you are only down 12%. A very obtainable come back!
• Now, let’s look at 18 losing trades and 2 winning trades over a 20-trade period.
• Use 1% risk with trade #5 and trade #18 winning 4% and 7% respectively (all other trades losing 1%): ~$92,000 account (only down 8% with 18 losses and 2 small winners)
• At 5% risk with trade #5 and trade #18 winning 10% and 12% respectively (all other trades losing 5%): ~$48,000 account (I upped the winners but the account was slashed in half – you now need to make 100% to break even).
• You claim that 18 losses over 20 trades won’t happen! Well, I must say you are dreaming in lala-land because it happens to the best in the business.
• If you risked 5% and lost 20 consecutive times, you would be left with approximately $35,000. How long will it take you to break even?
• At 1% risk, 20 consecutive losses bring you down to $81,000 (a tough string of losses but you are still in the game)! A 25% account gain breaks you even.

Now, image what most people start with: $10,000 or less! And then add the fact that they don’t know or understand how to properly position size – they are usually broke within a few trades because they bet the house on every trade and then emotionally freeze when things go wrong, taking losses of 25%, 50% or greater!

Finally, how should you diversify and how many stocks should you own in one portfolio? Well, this all depends on your position sizing strategy:

Using another quick example based on a $100,000 account.
Figure you want to buy two stocks at $50 (XYZ and ABC)

XYZ has major support at $48.50 with reward near $60. So the trade looks like this:
Buy 667 shares
3% stop loss
$33,350 position size
Stop Loss: $48.50
Risk (1-R): $1.50
Reward Target: $60
Risk-to-reward: 6.67-to-1

ABC has major support at $45.00 with reward near $65. So the trade looks like this:
Buy 200 shares
10% stop loss
$10,000 position size
Stop Loss: $45.00
Risk (1-R): $5.00
Reward Target: $65
Risk-to-reward: 3-to-1

As you can see, you will buy both stocks at $50 per share but due to stop areas and possible targets, the actual position size change from $33k to $10k (667 shares to 200 shares). It’s all about the risk, the reward and the correct position size. You could have a large $30k or $40k position due to a tight stop or a small $10k position due to a larger stop. Depending on the trade and your style, you may have 3 or 4 stocks for a $100k account or you could have 7 to 10 active positions (I wouldn’t do more than this at one time).