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 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 security they can purchase, which helps them to control risk and maximize returns.
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.