Position Trading #3: Position Sizing

In my previous installment I alluded to the fact that prudent position sizing can be used for money / risk management as a complement to, or a substitute for, stop orders. In this article we’ll look some more at position sizing.

What is Position Sizing?

Position sizing means deciding on the amount that you will ‘invest’ or ‘stake’ in a speculative position. Big position sizes produce greater gains, but at greater risk unless you also apply tight stop orders that might easily get triggered. Small position sizes reduce your risk, and increase your chances of staying in a position by applying a wide stop order (or none at all), but at the expense of less meaningful gains.

Here are two examples:

By staking £10-per-point on a Yell Group spread bet (current price 4p) you risk only £40. With this position size on this stock, you really don’t need a protective stop order no matter how volatile the price is.

By staking the same £10-per-point on a FTSE 100 spread bet (let’s assume a price of 5000) you stand to lose a much bigger £25,000 if the index falls by 50%. With a reduced position size of £1-per-point, your risk would be reduced to £2,500, and by also applying a stop order at 4960 you could reduce your risk to the same £40 that you risked on the Yell Group position.

These examples highlight the important relationship between position sizing and stop placement, and there is also an important relationship with money management. You shouldn’t be risking more than (for example) 1% of your trading capital per trade. In a £4000 trading account, the risk on each trade should be limited to £40, and my examples above show you how.

Position sizing need not be a static one-off decision. Some investors increase their position sizes by “averaging down” (not recommended) when their holdings fall in value, and some traders and investors increase their position sizes on winning positions by “pyramiding” — as will be described in my next installment.

Position Sizing in Position Trading

My approach to position trading is to establish very small exploratory positions initially, with the intention of exiting the position with the smallest possible loss (if it goes bad) or increasing the position size (by pyramiding) over time if it goes well.

In many cases the very small exploratory position size will be determined by the minimum allowed on the spread betting platform, typically £1-per-point, but of course this would be dependent on the overall account size and stop placement. A very tight stop or a very large account size would justify a larger exploratory position size.

When trading in a regular brokerage account rather than a spread betting account, the initial position size would be an amount large enough to be meaningful with respect to dealing fees yet small enough to account for (let’s say) no more than 2% of available funds. An initial exploratory position size in a £50,000 account might be £1000, and this position would not be increased — by pyramiding, next installment — until this could be done safely on a profitable position.

Tony Loton is a private trader, and author of the book ‘Position Trading’ published by LOTONtech