What is Position Sizing in Trading

by Feb 19, 2024Trading0 comments

Regardless of the type of trading you engage in, there is always an inherent risk involved. This risk becomes more significant when trading highly volatile assets like cryptocurrencies. Consequently, traders often adopt risk management strategies specific to crypto trading to limit potential losses. Position sizing is a prevalent approach to crypto risk management. Continue reading to understand the concept of position sizing and learn how it can effectively mitigate risk in your trades.

What Is Position Sizing?

Position sizing involves determining the number of units an investor or trader allocates to a specific security. When determining the appropriate position size, factors such as the investor’s account size and risk tolerance must be considered.

Position sizing is a trading strategy that involves predefining your entry and exit prices, as well as the overall risk, before executing a trade. For instance, you may choose to enter the market only after it surpasses a specific level, like the day’s high or week’s low.

The next step in position sizing is determining the appropriate trade size. If you have a smaller account, you may opt for mini or micro lots instead of standard lots. Additionally, trading a single lot at a time or using a tight stop-loss can help safeguard your trading capital.

When executed effectively, position sizing safeguards your trading capital and prevents significant losses from a single trade. Various position sizing strategies exist, including fixed-dollar amount, percentage dollar amount, and contract size value. Mathematical formulas like the Kelly Criterion can also assist in calculating the optimal position size.

The Importance of Position Sizing

Position sizing plays a vital role in trading performance as it significantly impacts your results. Opting for a too small position size hinders substantial profit growth, while overly aggressive position sizing puts your trading account at risk of complete depletion—an occurrence more prevalent than the former.

These scenarios represent the extremes in outcomes achievable through position sizing. Traders and investors must strike a balance between the two, aiming for high returns while maintaining acceptable risk levels. Traders who recklessly embrace excessive risk through careless position sizing may experience a few exceptionally profitable years. However, inevitably, the day will arrive when they face complete loss. Remember, the upside potential is limitless, while the downside risk is always capped at 100%. To calculate risk effectively and remain in the game, several position sizing techniques can be employed.

Position Sizing and Gap Risk

Investors must understand that even with proper position sizing, there is a possibility of exceeding their predetermined account risk limit if a stock experiences a significant gap below their stop-loss order.

In situations where higher volatility is anticipated, such as ahead of company earnings announcements, investors may consider reducing their position size by half to mitigate the risk associated with market gaps.

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The Best Position Sizing Strategies

Due to the extensive range of position sizing strategies available, it is impractical to cover them all within a single post. Hence, we will focus on highlighting the top and widely used position sizing strategies below:

1. Fixed Dollar Amount

Among the various position sizing strategies, the Fixed Dollar Amount method stands out as one of the simplest. It involves selecting a specific dollar amount that you are willing to risk and adjusting the number of contracts or stocks accordingly.

For instance, if you decide to risk $100 on a trade, you need to calculate the risk associated with that particular trade to ensure it aligns with your predetermined risk level. Here’s an example:

Let’s say we enter the market during a breakout and set our stop loss at the previous low. The entry and stop loss levels are indicated in the accompanying image below:

Fixed Dollar Amount

According to our position sizing strategy, we have a maximum risk limit of $100. Considering our entry point at approximately $181 and the set stop loss around $173, the calculated risk per share is:

$181 – $173 = $12.

To determine the number of stocks we can purchase based on the fixed dollar amount stop loss, we divide the stop loss by the risk per share:

100 / 12 = 8.3.

Therefore, based on this calculation, we can buy a maximum of 8 shares while adhering to our position sizing strategy.

It is worth noting that the number of stocks we can purchase is primarily determined by the placement of the stop loss, which can often involve a somewhat subjective decision-making process. Later in the article, we will provide tips on identifying suitable stop-loss levels.

2. Fixed Percentage Risk

The fixed percentage risk approach in position sizing is akin to the fixed dollar amount strategy, as it involves assigning a predetermined risk level for each trade. However, in the fixed percentage risk approach, a percentage-based measure is utilized. Numerous traders opt to cap their maximum risk to a few percentage points of their account equity. As a general guideline, it is recommended not to exceed risking more than 2% of your account in a single trade.

Nevertheless, this percentage is not rigid and can fluctuate based on factors such as diversification, experience, and individual risk tolerance. Increased diversification across various markets and strategies may allow for a higher level of risk. Conversely, following a paper trading phase, novice traders should exercise caution and opt for significantly lower risk levels.

3. Volatility-Based Position Sizing Strategy

The volatility-based position sizing strategy employs a volatility measure to determine the appropriate position size. Market volatility fluctuates over time, and higher volatility corresponds to larger price swings, which must be considered when sizing trades. Refer to the chart below, which utilizes the Average True Range (ATR) to gauge market volatility.

Volatility-Based Position Sizing Strategy

As depicted, volatility varies over time. Trading a contract with higher volatility entails a greater likelihood of significant price swings. Therefore, it is advisable to reduce the position size during periods of high market volatility and vice versa.

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However, for certain strategies, higher levels of volatility may indicate a stronger trading advantage. In such cases, increasing the position size might be appropriate. Nevertheless, it remains crucial to avoid risking an excessive portion of your trading capital in a single trade.

4. Fixed Risk Per Trade

The fixed risk per trade position sizing strategy is relatively more intricate, as it incorporates three distinct variables to determine the appropriate position size:

Stop Loss for the Total Trade Value:

This stop loss is calculated as a percentage of the stock price. For instance, if we set the stop loss at 10% and purchase a share trading at $100, the stop loss would be set at $90 on the price graph.

Calculation: $100 – ($100 * 0.1) = $90

Risk Per Trade as a Percentage of Trading Capital:

This variable aligns with the percentage-based position sizing strategy. By setting it at 2%, we ensure that we risk a maximum of 2% of our trading capital in each trade.

The Maximum Risk for the Trading Account as a Whole:

Here, we establish a limit on the amount of capital we are willing to have invested in trades simultaneously. A 30% maximum risk level indicates that we can only allocate up to 30% of our trading capital across active trades at any given time.

5. Averaging Down

This position sizing strategy carries a significant level of risk and should be approached cautiously. Averaging down involves adding more contracts or shares to a position if the market moves against you. By doing so, the average price of your position decreases, reducing the required stock price increase for a profitable outcome.

Averaging down is commonly employed in mean-reverting strategies, where it is most logical. As a market becomes more oversold, the likelihood of a reversion increases. However, one must remain vigilant. In the event of an unforeseen and extreme market event, averaging down can result in substantial losses, and therefore, it should be used with care.

The example below illustrates a trading strategy that enters when the Relative Strength Index (RSI) reaches oversold levels and subsequently employs averaging down as the market continues to decline.

Averaging Down

In this particular scenario, averaging down was performed twice, leading to a profitable exit from the trade, which would have resulted in a loss had averaging down not been employed.

6. Maximum Drawdown

The maximum drawdown position sizing strategy is predominantly employed when constructing portfolios consisting of various trading strategies. By combining multiple systems and assessing their collective performance, the aim is to identify uncorrelated strategies that optimize the drawdown-to-profit ratio.

However, the maximum drawdown method can also be utilized with individual strategies. For instance, if you set a maximum drawdown threshold of 30% of your capital and your trading capital is $100,000, the maximum allowable drawdown would be $30,000.

Suppose your strategy has experienced a historical maximum drawdown of $15,000. In that case, you may consider trading two contracts or doubling the number of shares.

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Important note: It is crucial to recognize that relying solely on historical drawdown to determine position size is not a foolproof approach. Often, it is advisable to at least double the historical drawdown figure to arrive at a more conservative number that can be used for decision-making in live trading.

7. Monte Carlo

Monte Carlo is a simulation technique that involves rearranging the order of trades within a backtest randomly. By conducting Monte Carlo simulations thousands of times, it becomes possible to generate statistical insights regarding the probability of a future drawdown reaching a specific dollar amount.

In essence, Monte Carlo testing extends the principles of the Maximum Drawdown position sizing strategy by acknowledging that future drawdowns are likely to surpass historical drawdowns.

How to Use Position Size to Manage Risk

Position sizing methods can play a crucial role in ensuring that each trade holds significance. Now, let’s delve into the details of how position sizing can be utilized in relation to both the size of your trading account and the specific trade you intend to execute. Also read How to Manage Risk When Trading Cryptocurrency.

1. Account Risk

The majority of professional traders adhere to a risk limitation of 1% of their total account balance per trade. Consequently, if you have $1,000 in your account, you would aim to avoid risking more than $10 at any given moment. While it may seem discouraging to have such a restricted maximum risk when starting out, it’s important to note that, as a beginner, your primary objective isn’t solely focused on making profits. Instead, your goal involves improving your emotional management, learning from mistakes, and cultivating sound position sizing habits in a relatively low-stress manner.

2.Trade Risk

Suppose you have set a maximum risk of $10 for a single trade, and the value of each price interest point (pip) is $1. In this case, if you intend to buy, it is advisable to place a stop-loss order no more than 10 pips below your entry price. Conversely, if you plan to sell, it is recommended to set the stop-loss order no more than 10 pips above your entry price. Also read How to Make Low-Risk Gains with Crypto Arbitrage | A Step-by-Step Guide.

3.Proper Position Size

This approach to position sizing assists in determining the number of lots you should trade in any given position. In general, the quantity of lots you choose to purchase is influenced by your level of confidence in the trade, as well as the size of the lot itself. Typically, a micro lot enables you to control $1,000 worth of the underlying asset, a mini lot allows control of $10,000, and a standard lot represents control over $100,000 of the underlying asset.

Conclusion

Position sizing ought to be recognized as a fundamental component of your comprehensive trading strategy. By employing position sizing consistently, you can potentially mitigate the risk of enduring devastating losses that surpass your initial investment. Additionally, it aids in the management of emotions, which can pose a particular challenge for novice traders.

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