Jul 17, 2007

Position Sizing and its importance

"Position Sizing" is one of the important techniques that every trader should know and be using in their trading. Most Professionals use Position sizing of some kind but many new investors don't. I would urge you to spend some time to understand this powerful concept.

Position Sizing is the technique of determining "how much" money to place for any single trade. That is, should you place 5% or 10% or 20% of your available money in a given trade. Seems like a simple question, but the outcome of this simple question can make a big difference.

Dr.Van K Tharp did experiments to determing the effects of Position Sizing and has documented them in his book, "Trade your way to Financial Freedom". He tested the four position sizing models with all the parameters same, except for the size of each trade. The results revealed that for the same trading system, the model that used percent risk (percentage of total available - discussed below) and the model that used percent based on volatility (discussed below) fared many times better when compared to fixed-dollar models. More details of this result can be seen here.

The key take away message from that experiment is that we need to focus on two models to get better results and they are position sizing based: (1) on percentage of total risk and (2) on percentage based on volatility.

All the notes below is from Michael Taylor's blog and the credit entirely goes to him.

Let us define two types of risks to simplify our calculations. Equity Risk (ER) is the percent of the total equity that you can risk for a trade. Say, you are willing to risk 2% of your total equity of $50,000. Then, ER = 50,000 x 0.02 = $1,000. Stock Risk (SR) is the risk you are willing to take in the stock price itself. It also means the percentage point where you would put stop loss for your stock trade. Say you would have put 10% stop loss on a $25 share, then your SR = $25 x 0.10 = $2.5.

Now, the Percentage Risk Model gives us the following dollar amount that we should invest.
ER = $50,000 * 0.02 = $1,000
SR = $25.00 * 0.10 = $2.5
Number of shares = $1000/$2.5 = 400 shares
Dollar Amount = num shares * share price = 400 shares * $25 = $10,000
If cash on hand is less than this amount then just take the cash on hand and divide it by the price of stock. Let's say cash on hand was only $5,000 then this would be: $5,000 / $25 = 200 shares

If you noticed, the previous method did not adjust the size of the trade according to the volatility of the stock. Conventional wisdom tells us to decrease the position size when the stock is volatile and increase the size when the stock is not so volatile.

There are many ways to acheive this, and the following is one of the ways.
Current Range (CR) = 10 day high - 10 day low
Maximum Range (MR) = highest value of the (10 day high - 10 day low). That is, look at the historical chart for the stock and record the maximum price swing that ever happened to this stock. This is not hard to get as it sounds like, just identify the time when you saw the biggest jump or biggest drop in the chart, then lookup historical prices table in yahoo to determine this.
Number of Shares = [(1 - (CR / MR)) * ER) / SR]

Example: Equity Risk (ER) = $50,000 * 0.02 = $1,000
Stock Risk (SR) = $25.00 * 0.10 = $2.5
Current Range (CR) = $30.00 (10day high) - $20.00 (10day low) = $10.00
Maximum Range (MR) = $60 back a few years ago.
Shares = (1 - ($10 / $60)) * $1,000) / $2.5 ~ 330 shares
Dollar Amount = 330 shares * $25 = $8,250

These calculations are some ways other traders use to size their positions, and you should do your own calculations to suit your comfort and interests.

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