Last Updated on 17 November, 2020 by Samuelsson
Position Sizing is one of the most important aspects of profitable trading, but is often neglected or not cared about by novice traders. In this guide, we will cover some of the best position sizing strategies.
The best position sizing strategy is not the same for every trader and varies by trading style and personal risk tolerance. However, if there was one rule by which all traders had to obey, it would be to risk a maximum of a few percents of the account in every trade. The exact percentage then varies with the level of diversification and the overall risk of your trading strategy.
If you want to discover which position sizing strategy is the best fit for you, this guide will help you to find out!
What Is Position Sizing?
Position sizing is the process of determining the size of a trade and has significant effects on the performance of your trading or investment portfolio. Many new to trading make the mistake of taking on to large positions, in the belief that they will make easy and quick profits. In the long run, this type of behavior more often ends in despair over large losses than the opposite.
The Importance of Position Sizing
Position sizing is important because it has a substantial effect on your trading performance. If you choose a position size that is too small, your profits will never grow at a significant rate. Conversely, if you are position sizing too aggressively, you run the risk of totally wiping out your trading account. As you might have already guessed, the latter is more common than the former.
These two above scenarios depict the two extremes in results that can be achieved through position sizing. Traders and investors will have to strike a balance between the two, in order to achieve high returns at acceptable risk levels. A trader who takes on massive risk through careless position sizing may have a couple of extraordinary years with high returns. However, sooner or later, the day will come when he or she is wiped out completely. Remember, the upside is limitless, whereas the downside is always capped at 100%.
[bctt tweet=”Position sizing is paramount because the downside is only 100%, whereas
the upside is limitless.”]
So, what position sizing techniques can you employ to calculate risk and ensure that you are staying in the game? Well, there are a couple of methods:
The Best Position Sizing Strategies
There are countless of position sizing strategies, and it would be impossible to mention them all in one post. Therefore we are only listing the best and most common position sizing strategies below:
1. Fixed Dollar Amount
The Fixed dollar amount if one of the simplest of all position sizing strategies. You just choose the dollar amount you are willing to risk and adjust your number of contracts or stocks accordingly.
So, if you are willing to risk $100 on a trade, you will first have to calculate your risk on that very trade to be able to adhere to your risk level. Here is an example:
We enter the market on a breakout and set our stop loss at the previous low. The entry and stop loss are marked in the image below:
Our position sizing strategy tells us to not risk more than $100. Since we enter at around $181 and our stop loss is set to around $173 our risk is calculated as:
$181-$173 = $12.
To know how many stocks we can buy with the above set stop loss level, we divide the fixed dollar amount stop loss by the risk per share:
From doing this calculation we now know that we can buy a maximum of 8 shares if we want to comply with our position sizing strategy.
As you might have noticed, the number of stocks we can buy is totally dependent on where we place the stop loss, which often is a somewhat arbitrary decision. Later in the article, we will give you some tips on where you can place the stop loss.
2.Fixed Percentage Risk
This position sizing strategy is similar to the fixed dollar amount approach, in that we assign a certain predetermined risk for each trade. However, with the fixed percentage risk approach, we use a percent based risk measure instead. Many traders choose to limit their maximum risk to a few percents of the account equity, and as a rule of thumb, you should not risk more than 2% of your account in one trade.
However, this number is not set in stone and varies with factors like diversification, experience, and personal risk tolerance. With more diversification across different markets and strategies, you may safely risk more. However, somebody new to trading, should, after ending their paper trading period, risk a lot less.
One of the benefits of using a fixed percentage position sizing strategy is that your position size automatically adapts to the size of your account. With the fixed dollar amount, you would need to recalculate the size of the maximum dollar amount risked, as your account grows or shrinks. This is taken care of for you automatically when using the fixed percent position sizing strategy, and your account growth will accelerate with time as a result of compounding.
Of course, the very same thing can be accomplished with a fixed dollar amount position sizing strategy, but it requires more work as you constantly need to change the dollar amount with the fluctuations in equity balance.
To calculate the amount you may risk in every trade, you just add another step to the fixed dollar amount approach.
If we assume that we want to risk a maximum of 2% of our account, and we trade a $1000 account, our maximum risk in any trade becomes $200. From here on, the calculation goes as for the fixed dollar amount position sizing strategy.
3. Volatility-Based Position Sizing Strategy
Volatility based position sizing strategy uses a measure of volatility to determine the position size. Market volatility varies with time, and with higher volatility comes greater swings, which needs to be taken into account when sizing your trades. Have a look at the chart below. It uses ATR (Average True Range) to determine the volatility of the market.
As you can see, the volatility changes with time. Trading a contract with higher volatility means a greater chance of big swings. Therefore you should decrease the position size during volatile market environments, and vice versa.
However, for some strategies, higher levels of volatility could mean that the edge gets stronger. In those cases, you might want to increase the position size instead. Still, it is important to not risk too much of the trading capital in one trade.
How to Apply Volatility Adjusted Position Sizing
There are countless ways to measure volatility to come up with the right position size. You could compare the short term range to the longer term range, or use set volatility thresholds in the ATR indicator to determine how volatile the market is.
4. Fixed Risk Per Trade
The fixed risk per trade position sizing strategy is somewhat more complicated. It uses three different variables to determine the position size:
- Stop loss for the total trade value
- Risk per trade as a percentage of account equity
- The maximum risk for the trading account as a whole
What Are the Benefits of This Position Sizing Strategy?
The fixed risk per trade position sizing strategy has its benefits in that it not only takes into account the risk at the single trade level but also at the portfolio level. With the fixed percentage risk approach, there is no cap on how much all trades may risk together. If you hold 100 trades at the same time, with each risking 2%, you are risking 100% of your capital. The fixed risk per trade approach removes this risk by setting a cap on the maximum portfolio risk.
4. The Kelly Criterion
The Kelly Criterion is a formula that was developed by John L. Kelly and is widely used by traders and gamblers to determine the position size for each trade/bet.
The formula is as follows:
Kelly % = trading capital to use in one trade
W = The win percentage of the trading strategy
R = The historical Win/Loss ratio
One of the main advantages of the Kelly Criterion is that it takes the historical, backtest performance of the trading strategy into consideration. That way, the position size is adjusted for the particular trading strategy that you trade.
How to use the Kelly Criterion
- Collect data about your last 50 trades. If you are trading a backtested trading strategy you may get this from the backtest report. Discretionary traders may view their recent trades at their broker’s website.
- Calculate the win probability, which is the “W” in the formula above.
- Calculate the win/loss ratio, which is the “R” in the formula above.
- Put the numbers into the equation, and find out your Kelly Percentage
The percentage that you get represents the position size of your next trade. Hence, if your calculation outputs 0.02, your next trade should be made with 2% of your trading capital.
5. Averaging Down
This position sizing strategy is quite a dangerous one and should be used with caution. Averaging down means that you keep adding contracts/shares if the market moves against you. By doing so, your average price decreases and you reduce the amount that the stock must rise for you to make a profit.
Averaging down is used most with mean-reverting strategies, and that is also where they make the most sense. The more oversold a market becomes, the greater the chance that it will revert soon. Still, one has to be vigilant. In the case of a black swan event averaging down could cause massive losses, and should be used with caution.
Below you see a trading strategy that enters when the RSI becomes oversold, and then averages down as the market continues to plummet.
In this case, we averaged down two times, and because of this we exited the trade with a profit, as opposed incurring a loss if we had not averaged down.
5. Maximum Drawdown
The maximum drawdown position sizing strategy is mostly used when creating portfolios with different trading strategies. By combining many different systems and see how they perform together, you work towards finding uncorrelated strategies that maximize the drawdown-to-profit ratio.
Still, you can use the maximum drawdown method with individual strategies. If you set the maximum drawdown that you are willing to accept to 30% of your capital, and you are trading $100 000, your maximum drawdown is $30 000.
Now, if your strategy in the past has performed $15 000 in maximum drawdown, you may trade two contracts or double the number of shares.
Important! Keep in mind that using historical drawdown to determine the position size is by no means a safe approach. Often you must at least double the historical drawdown to come up with a number that can be used for decisionmaking in live trading.
6. Monte Carlo
Monte Carlo is a simulation method that works by taking all the trades in a backtest and randomly change the order of them. By running Monte Carlo up to tens of thousands of times, you can produce a statistical measure of the likelihood that a future drawdown will stretch to a certain dollar amount.
Monte Carlo testing thereby is a continuation of the Maximum Drawdown position sizing strategy, that takes into account that future drawdowns are likely to exceed historical drawdowns.
How to Know Where to Put the Stop Loss
Since the stop loss in many position sizing strategies is what determines the position size, it is important to know where they should be placed. Here follow some different approaches to placing stop losses.
Around Resistance and Support Levels
Resistance and support levels are zones where the market tends to revert. Putting the stop loss right under or above a support or resistance level, depending on whether you are going long or short, is one common approach.
To better understand how to use support and resistance, we recommend you to read our nearly 4000 words long article that goes into depth on the topic!
Adjusting the Stop Loss Based on Volatility
Even if you do not use a volatility based position sizing strategy, you must take the volatility level of the market into consideration. Putting stop losses too close to the entry will result in you getting stopped out of your trade before the market even has had a chance to develop in the direction of your trade.
The best stop loss distance for a market can be determined by either backtesting the trading strategy, or observe the ATR indicator. Typically, a stop loss that is placed around 3 times the ATR value from the entry works well.
Beware of Contract Sizes
When trading stocks, position sizing and calculating the risk is not hard. You know at what price the stock trades, and can calculate the position size with ease. However, with other securities, such as futures, it is not as easy.
When trading futures you need to be aware that you are trading with leverage. While there is a margin rate that you need to comply with, meaning a sum of money that you need to keep on your account, the actual size of the contract, as well as the risks that come with it, are much greater. The margin is only a fraction of the total value of a futures contract, and cannot be used to gauge the risk.
Instead, you need to look at the point value of the contract. A point value of, for instance, 20 dollars, means that a move of one point equals $20. So, if your entry was at 1920.00, and your stop loss is at 1910, that means that you are risking $200.
(1920-1910)*$20 = $200
Where To Find More Information
For traders who wish to learn more about position sizing, we recommend Van Tharp’s book ” Definitive Guide to Position Sizing“. It is the most extensive guide on the market right now.