Tuesday, April 22, 2008

Position Sizing, How Much Should I Invest?


There are many theories and techniques that professional traders use to size their positions. For some, it can be very formulaic, especially for forex traders, taking the human element out of the equation and let the computer do the work. A properly sized position can mean the difference between great gains and spectacular losses.

For the average investor, position sizing is equally important. The difference is, we don't have and need sophisticated systems and formulas to calculate our positions.

There are many techniques to determined a properly sized position, but I'm going to describe just two, that are straight forward and easy to use. The two methods are Risk Sizing and Martingale. In this post I'm going to describe Risk-based Position Sizing. I will follow up in another post to describe Martingale Sizing.

Risk-based Position Sizing
The first step is to determine how much you're willing to risk, as a percentage of your total trading capital. Studies have shown that the optimum amount of capital to risk per trade is 2%. So, if your investment capital is $100,000, then you shouldn't risk more than $2000 per trade. This amount will be used to determine your stop. Everything else in your setup, will be based on this point.

So, let's look at an example. Suppose you have determined that there's strong support for AAPL at $160. This will be your stop. The price is currently at $163, and you believe the next resistance point is $170. This translates to a risk-reward ratio of 1:2. Or $3 at risk, $6 of potential profit. So $3 is your risk, let's figure out how that translates to $2000, by dividing 2000 by 3. We get 667 shares. So, if you buy 667 shares at $163, and set your stop at $160, your maximum loss is $2000.

Figuring in Volatility
Now, in reality, this is not a very practical model, because AAPL can move $3 in the blink of an eye. I should take that into account, and look at the next resistance level I can use, let's say $158. Now the number of shares works out this way, my entry of $163 minus $158, or $5, divided into my risk capital of $2000 equals 400 shares. But now my risk-reward ratio is pretty close to 1:1. This just might not be the trade for me, because I'm looking for at least a 1:2 ratio. Unless I have reason to believe that AAPL will make it to $173, then I'm all set.

I usually create setups in advance. Sometimes several at a time, so that in the following trading sessions, I'll have various potential setups that I can choose from, and try to enter the ones that looks most promising according to the market and stock price action in that session. To make my setups practical, I should have a potential range of entry price. This will affect two things, 1) the number of shares I can buy, and 2) the risk:reward ratio. This is because, the stop is pretty much a hard stop, not flexible, determined by support levels that exist.

So, if my entry range is $2-$3 dollars, I have to understand the affect on my risk-reward ratio, and the number of shares I can buy. This is why it is advisable to create multiple setups, so that you can monitor them and enter those that present the greatest chance for success.

-zach bass

1 comment:

Unknown said...

I was wondering how did you decide on a stop of 172 and a target of
193.