What is 'Position Sizing'

Position sizing refers to the number of units invested in a particular security by an investor or trader. An investor's account size and risk tolerance should be taken into account when determining appropriate position sizing.

BREAKING DOWN 'Position Sizing'

Position sizing basically refers to the size of a position within a particular portfolio, or the dollar amount that an investor is going to trade. Investors use position sizing to help determine how many units of a security they can purchase, which helps them to control risk and maximize returns. (For further reading, see: Optimal Position Size Reduces Risk.)

Position Sizing Example

Using correct position sizing involves three steps:

  • Determining Account Risk: Before an investor can use appropriate position sizing for a specific trade, he must determine his account risk. This typically gets expressed as a percentage of the investor’s capital. As a rule of thumb, most retail investors risk no more than 2% of their investment capital on any one trade; fund managers usually risk less than this amount. For example, if an investor has a $25,000 account and decides to set his maximum account risk at 2%, he cannot risk more than $500 per trade (2% x $25,000). Even if the investor loses 10 consecutive trades in a row, he has only lost 20% of his investment capital.
  • Determining Trade Risk: The investor must then determine where to place his stop-loss order for the specific trade. If the investor is trading stocks, the trade risk is the distance, in dollars, between the intended entry price and the stop-loss price. For example, if an investor intends to purchase Apple Inc. at $160 and place a stop-loss order at $140, the trade risk is $20 per share.
  • Determining Proper Position Size: The investor now knows that he can risk $500 per trade and is risking $20 per share. To work out the correct position size from this information, the investor simply needs to divide the account risk, which is $500, by the trade risk, which is $20. This means 25 shares can be bought ($500 / $20).

Position Sizing and Gap Risk

Investors should be aware that even if they use correct position sizing, they may lose more than their specified account risk limit if a stock gaps below their stop-loss order. If increased volatility is expected, such as before company earnings announcements, investors may want to halve their position size to reduce gap risk. (For more, see: Do Stop or Limit Orders Protect You Against Gaps?)

RELATED TERMS
  1. Gap Risk

    Gap risk refers to a security’s price changing from one level ...
  2. Bid Size

    The bid size represents the minimum quantity of a security that ...
  3. 2% Rule

    The 2% rule is a money management strategy where an investor ...
  4. Tick Size

    A tick size is the minimum price movement of a trading instrument. ...
  5. Contract Size

    Contract size is the deliverable quantity of commodities or financial ...
  6. Equity Market Capitalization

    Equity market capitalization is the measure of the total market ...
Related Articles
  1. Investing

    Optimal Position Size Reduces Risk

    Finding the right position size can minimize loss for a trader.
  2. Investing

    Explaining the Common Size Income Statement

    A common size income statement expresses each account as a percentage of net sales.
  3. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  4. Trading

    Money Management Matters in Futures Trading

    Learn how this overlooked area of trading can help improve your gains.
  5. Trading

    Controlling Risk With Options

    Options traders must learn how to control and capitalize upon leverage in order to control risk.
  6. Insights

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  7. Financial Advisor

    The Importance of a Client's Risk Assessment

    Financial advisors and money managers must do a detailed risk assessment regarding each client before they can recommend a course of action.
  8. Investing

    Fund Size and Performance

    Bigger is not necessarily better when it comes to asset size in a mutual fund. Find out why.
RELATED FAQS
  1. Stop-Loss Order

    A stop-loss order specifies that an investor wants to execute a trade for a given stock, but only if a specified price level ... Read Answer >>
  2. What are the major categories of financial risk for a company?

    Examine four major categories of financial risk for a business that represent potential problems that a company may have ... Read Answer >>
  3. Financial Risk vs Business Risk

    Understand the key differences between a company's financial risk and its business risk – along with some of the factors ... Read Answer >>
  4. How does market risk differ from specific risk?

    Learn about market risk, specific risk, hedging and diversification, and how the market risk of assets differs from the specific ... Read Answer >>
  5. Why are mutual funds subject to market risk?

    Find out why mutual funds, like all investments, are subject to market risk, including how the different types of market ... Read Answer >>
Trading Center