For an archive of The Daily Breakdown’s 5-Day Bootcamp, see the guide below:
Bootcamp Day 1: Picking a strategy
Bootcamp Day 2: Every strategy has a time and place
Bootcamp Day 3: Position sizing
Bootcamp Day 4: Trading around big events
Bootcamp Day 5: What to do during corrections
Position sizing can be one of the top reasons why investors struggle. What may seem like an innocent position can quickly turn into a portfolio-destroying regret with one swift move in an unexpected direction.
The reality is, many investors don’t actually know how to calculate a proper position size for their strategy. So we’re going to look at several ways to do so.
Calculating position size
Some investors look at the position purely on a portfolio percentage basis. For instance, if they have a $10,000 portfolio and don’t want any position to make up more than 20% of their portfolio, then each position would be $2,000 or less. This is a good way to stay diversified and make sure that one position doesn’t make up too much of one portfolio.
Another way to calculate position size is based on risk.
Let’s recall this week’s previous example of XYZ shares trading at $20. Say an active investor has a $10,000 portfolio but doesn’t want to risk more than 2% to 3% of the portfolio’s value on any one given trade.
In this example, say they examine the setup and conclude that the trade is no longer valid if XYZ — which is trading for $20 — drops below $19. In this scenario, they have now calculated their stop-out level ($19), which equates to a risk of $1 a share.
If they are not willing to risk more than 2% to 3% of the portfolio on any given trade, that means they are willing to risk $200 to $300. With $1 a share in risk, this investor can justify a position size of 200 to 300 shares.
Critical consideration: One thing to keep in mind is, not everything goes to plan. Just because the investor plans to risk $1 a share, doesn’t mean that something worse cannot happen. For instance, the company could announce bad news and shares could open lower by $3 a share before the investor has an opportunity to react. That’s why some traders will use a combination of position size tools. For instance, planning to risk no more than 2% to 3% of the portfolio value on the trade based on the calculated risk and not having any one position make up more than 20% of their portfolio.
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It’s okay to stop-out
It’s never fun to take a loss. It stings the portfolio and bruises the ego. But over time, we become more accustomed to taking losses, realizing that they are just part of the process.
The goal is to take a small paper cut on the loss, not a life-threatening gash.
One common saying in the investing world is that an investment should have one of four outcomes: A big win, a small win, a flat result, and a small loss.
Notice the one thing that’s missing? Yep, “a big loss.” Big losses create deep holes for our portfolios to dig out of. Using stop-losses and proper position sizing are just two tools every investor has at their disposal to try and prevent themselves from getting in that situation.
One other “option”
Trading options comes with a few other concepts to learn, but one key advantage options hold over other assets? Risk management.
Bullish investors can utilize calls or call spreads to speculate on upside, while bearish investors can use puts or put spreads to speculate on downside. In either case, both are buyers of options, and options buyers limit their risk to the price paid for the trade.
Take our investor from above, who doesn’t want to risk more than $200 to $300 on any given trade. So long as their long options position is at or below this range, that is their maximum risk for the trade.
This allows options to serve as a useful way to measure position size.
For those looking to learn more about options, consider visiting the eToro Academy.