Position Sizing in Trading
Position Sizing in Trading
Position sizing is an incredibly important aspect of trading that refers to the size of a trade or the number of shares/contracts purchased.
In other words, it is the process of determining how much of your trading capital to allocate to a particular trade.
Position sizing is critical to successful trading, as it plays a key role in risk management and emotional trade management, so trust me when I say size matters.
Learning how to properly size positions can easily be the difference maker in any trader’s profitability.
With that in mind, we’re going to take a look at all the ways you can turn position sizing into a tool that enhances your trading.
Why Does Position Sizing Matter?
Risk Management
In the simplest terms, position size matters because the bigger the position, the more money you are risking.
It isn’t exactly rocket science, but the more money you put into a trade, the more you can lose, so it’s crucial to manage risk by determining an appropriate position size for each trade.
If you don’t want to lose more than $20, you probably shouldn’t choose $5,000 positions.
Conversely, if you’re comfortable losing $100 on a trade, you probably shouldn’t choose $500 positions.
A well-defined position size that considers exactly how much money is at stake in any given trade is indispensable to limiting risk and preventing large losses.
In short, adjusting one’s position size is one of the easiest ways to manage risk as a trader.
Emotional Influence / Trade Management
Anyone with experience trading knows just how emotional it can be, and position size is one of the main reasons why.
The size of a trade has a powerful impact on how you manage it because it’s directly related to how much money you can win or lose, which tends to trigger emotional reactions.
If your position is too big, you might get scared out of a good trade, which leads to missed opportunities.
On the other hand, if your position is too small, you might hold onto trades when you should take profits or, perhaps even worse, let a bad trade turn into a worse trade because it’s relatively small in dollar terms.
In either case, your position size can have a material impact on the trade that leads you into an emotionally-driven mistake.
Trading is best executed according to a well-defined plan, not according to some arbitrary profit or loss number, so avoiding that emotional impact by sizing positions correctly is essential to success.
If your trade thesis has not been invalidated, the dollar amount you are down should be of little concern (assuming you size your position correctly).
However, if you are risking too much with a large position, you might be forced into an emotional exit to protect your capital.
Ideally, traders will avoid letting emotions influence their decisions. This is naturally much easier said than done, but sizing your positions appropriately is one of the best ways to keep a level head.
How to Choose Proper Position Sizes
Determine Your Risk
The first step in choosing an appropriate position size is always determining your risk.
This means deciding exactly where you will exit the trade if it moves against you.
The harsh reality of trading is you are going to take losses all the time, so you need to plan for them. Be intentional about your exit levels.
Get out at $5.02, not “around $5”.
Determining your risk (exact exit level) will depend on your own strategy, analysis, and risk tolerance, but, at the very least, you’ll want enough wiggle room to avoid getting whipsawed out of otherwise good trades.
Having too large of a position can encourage traders to tighten their stop-loss, but that often leads to losing trades that would have made money if given the right amount of breathing room.
This doesn’t mean you should have super liberal stop-losses, but you shouldn’t let your position size force you into overly tight stops.
For example, say you wanted to buy $F at $12.25.
A stop 10¢ below your entry at $12.15 may not be practical because it's within the natural range of volatility.
In other words, you would probably get stopped out during relatively insignificant ups and downs.
However, a stop 50¢ below at $11.75 could eliminate the risk of being whipsawed and taken out of the trade too early.
That said, your stop price should always be at the point where the trade thesis is invalidated, not at a random level.
If the invalidation level seems too far away, consider reducing your position size until that risk feels tolerable.
But remember, if price reaches that level, you get out of the trade without hesitation. Determining your risk is only helpful if you stick to it.
Whether your exit is the break of a trend line, above a resistance level, a push below the previous day’s open, or anything else, just ensure your exit level is clear and you’ll commit to it before you ever enter the trade.
Having a well-defined exit point is the only way you can have a well-defined risk, so simply ask yourself, where exactly does price need to go for my trade theses to be invalidated?
Determine Your Max Dollar Risk for the Trade
Once you know exactly where you plan to exit a trade (you’ve determined your risk), you can determine your max dollar risk for the trade.
While it’s wise not to focus on your P&L when you trade, you should always know roughly how much money you are risking.
For example, if you enter a stock at $10 and plan to stop out at $9, there is a $1 risk per share.
A position of 100 shares, then, suggests a max risk of $100, whereas a 1,000-share position suggests a max risk of $1,000.
The move in percentage terms will always be the same, but those two positions translate to very different dollar outcomes some traders may not be keen to accept.
The level at which you exit a trade should be objective and consistent with your analysis, but it also needs to be reasonable in dollar terms.
Your analysis may tell you to wait for a break below support to exit the trade for a loss, but that doesn’t mean you’re okay with losing $1,000 if it does.
However, by using your position size, you can have an objective exit level that aligns with a dollar amount you are comfortable risking.
Just pick your objective exit level based on your analysis (determine your risk) and move your position size up or down until that risk reflects a risk in dollars you find agreeable.
The dollar amount you are risking is ultimately what makes you emotional, so it should always be a factor in your position sizing.
Consider the Trade Management
How a trader manages their trade is another crucial component to determining position size.
Do you tend to get greedy when you have too small of a position?
Do you get scared and stop out early with too big of a position?
If your answer to the first question is yes, increasing your position size can actually help you take profits.
Nobody wants to exit a trade after $1 of profit, but if that’s all you’re making on a good trade, you might be sizing too small and driving yourself to hold onto positions longer than you should.
Now, if your answer to the second question is yes, you could seriously benefit from reducing your position size.
Having a comfortable position size is sometimes all you need to hold onto a trade through all the ups and downs.
If you catch yourself being too focused on your P&L, lower your position size until you can stick to your plan and commit to your predetermined exit levels.
It won’t always be easy to gauge, but knowing how position size affects you and how you manage a trade in real time will be a very important factors in your trading.
Consider the Asset’s Volatility
To truly manage risk, traders should also consider the position’s volatility.
A $1,000 position in $AAPL, for example, is not the same as a $1,000 in $AMC.
Traders frequently overlook volatility as a factor, but understanding its relationship to position size is crucial to managing risk.
A stock that frequently moves 10% in a day naturally carries more risk than a stock that moves 1% in a day, so your position size should take that into account.
Trading more volatile assets often means you are using wider stops, so if you want to risk the same amount as other trades, you’ll need to reduce your position size.
Consider Your Conviction
Another very important point to remember is that traders don’t need the same position size or dollar risk for every trade.
Instead, you can match your position size according to your conviction in a setup.
For example, if you’re 60% confident in a setup, you could take a $600 position, and if you are 80% confident, you could bump it up to an $800 position.
No trade is exactly the same, so why should your position sizes be?
If you have more confidence in a trade, increase your size.
If you aren’t too sure about a trade, take a smaller position.
Managing position size based on conviction is sometimes all the edge a trader needs to be profitable.
Consider Scaling In and Out of Positions
Another way to manage risk with position size is to scale in and out of positions.
This means buying or selling a portion of your position rather than all at once.
Many traders implement scaling in and out into all their trades as a way to manage risk or take profits, but you can sprinkle it in as you see fit as well.
For example, if you are trading a breakout, you could limit your initial buy to 50% of your total position size. If the breakout starts working, you can then buy the last 50% on a retest.
Doing this dramatically limits your risk in the event the breakout doesn’t materialize and the position goes against you.
Similarly, if you are up a sizable amount on a position, feel free to take some off the table and let the remainder ride.
This way, you can secure profits on a successful trade while also benefiting from any potential added gains from holding on.
Many traders view trading as binary (win or lose), but scaling in and out of trades is a great way to avoid that all-or-nothing mindset.
Scaling in and out of positions can help traders take smaller losses or have bigger wins, so definitely don’t rule it out as an option.
You don’t have to start or end with your full position. View your position size as flexible and adapt it to your trades by strategically scaling in and out when appropriate.
Conclusion
All in all, position sizing is a crucial aspect of trading that should not be overlooked.
By properly managing your position sizes and the emotional influences that follow, you can greatly increase the chances of long-term success in your trading.
Just remember to determine your risk (including a max dollar risk), know how you’ll manage your positions, take into account the asset’s volatility, match your position size to your conviction, and consider scaling in and out of your trades.
Position sizing is one of a trader’s greatest tools, so use it to your advantage because you don’t have to take on the same position size or dollar risk for every trade.
Hopefully, with these position size strategies and considerations, you can take your trading to the next level.