What is position sizing and why apply it?
Position sizing refers to the ideal number of units invested in a security given your 1) account risk and 2) trade risk. While many traders determine order sizes randomly, calculating proper position sizing will help you control drawdown risk if your bet goes against you, and optimize profits if your trade idea materializes. Traders should calculate their ideal position sizing using an informed and strategic methodology – rather than letting the gut feeling influencing their decision making.
How to calculate your ideal position size
The first step towards applying appropriate position sizing is to determine your account risk. Typically, this is expressed as a percentage of your entire account value (cash at hand + invested money). A rule of thumb among retail traders is to use no more than 2% of your account value, meaning you’re never putting more than 2% of your account value at risk.
For instance, if you got an account value of USD 100,000 (80,000 in cash and 20,000 in securities), you should not risk more than USD 2,000 on any given trade.
The advantage of applying the 2% rule is that if you’re strictly adhere to it, you would have to make dozens of consecutive 2% losing trades in order to lose the money in your account.
Bear in mind that the 2%-rule is just one way of determining your account risk. You should pick any percentage you’re comfortable with, as for instance 1%. You can learn more about determining your account risk by using the 2%-rule here.
Following determining the account risk, you need to identify where to place your stop-loss for the given trade. If you’re trading shares, the trade risk is the distance between the entry-price and the stop-loss price.
For instance, if you’re planning to buy Microsoft at USD 250 and place a stop-loss at USD 230, your trade risk is USD 20 per share.
One way to determine stop-loss levels is to use the average true range method, which you can read more about here.
Ideal position size
The ideal position size per trade is calculated by dividing the account risk by the trade size. In our Microsoft example, this equals USD 2000/USD 20 = 100. In other words, given your account value and stop-loss level, you can buy 100 Microsoft shares to make sure you’re not losing more than 2% of your total capital.