Position sizing in trading

When it comes to trading, it is usually finding good trades that gets the most attention. Simply finding situations where you want to take positions. Perhaps not so strange, as it is undoubtedly the most exciting part of it all. A trader looking for good setups can easily be compared to a hunter looking for wild game. They share many of the same principles, and this was something I kept coming back to in my book.

Own methods for finding setups with good risk/reward are central for every trader. This includes the patience to wait, but also the ability to react quickly when an attractive opportunity presents itself. Before you click on buy or sell, however, there are a number of practical matters that must be clarified. Not just what you do, but how you do it. Chief among these is choosing the right position size.

A long-term investor likes to consider the size of the position in relation to his total capital, in the same way as traditional mutual funds do. A good rule of thumb in a broad portfolio can be to have no more than 1/10 invested in each individual share. If you are to take a position in an index or a fund, it can naturally be significantly larger, as a fund/index is in itself diversified.

For a trader, the mindset is different. Here, too, the position must be assessed against the available capital, but since a trader normally sits much shorter in the position and often trades with leveraged products, the assessment is different. It is how large a proportion of the capital one wants to risk on the trade that should be decisive for the position size. This is calculated as the difference between the entry price and stop-loss on the position multiplied by the number of shares and viewed in relation to total equity. This may be unfamiliar if you have not thought in this way before, but we will show an example below.

Before making a specific calculation, however, a trader must decide how much of the capital he/she is generally willing to risk on a single position. A good suggestion is to have 3 levels of risk-taking and set these up as fixed units. If you think you have found a very good setup in a good market climate and a liquid instrument, you can e.g. risk maximum of what one is willing to bet. Call it e.g. R1 for risk level 1. A moderately good setup can be called R2 and in a quick trade that suddenly appears you can risk R3. Which values ​​you add to these will be individual, but for the sake of the example we can say that it can be R1 = 1 % of the capital, R2 = 0.5% and R3= 0.25%.

With this established, the specific position sizes can be calculated. Let's say you have USD 100,000 in total capital, trade a very liquid index instrument on the S&P 500 that is un-geared and identify a situation where you want to take a maximum position (R1). The instrument is currently trading at 400, having recently reversed higher after testing technical support at 397.50. Your scenario is based on this level holding, and you set 397.40 as stop-loss. The following can then be calculated:

                R1 = 1% of capital = 100.000/100 = 1000 USD.

                Position size = 1000 / (400 – 397,4) =  385

In this case, you therefore buy 385 units of the instrument for USD 400 and place a USD 2.4 stop. Note that the position in this case is worth 385 * 400 = 154,000 USD, or approx. 1.5 times your equity. This can be the case when the distance to the stop is very short, and USD 2.6 compared to 400 is only 0.65%. It is only in very liquid instruments (often index instruments) and where you are as sure as possible of being able to come out on your stop-loss that something like this is typically done. I myself often make trades in indices with tighter stops than this.

Many traders look at the underlying (e.g. an index like the S&P 500, or a commodity like oil) to determine entry and stop-loss but take the actual position in a trading instrument that is leveraged. It is then important to adjust for leverage in your calculation. If the risk calculation indicates a position of 1000 but you choose to buy a 3 x leveraged instrument, you must reduce the position size accordingly, i.e. to 333 to have the same risk. It is also required that the other components, such as liquidity and the possibility to set a well-functioning stop-loss, are present.

It is important to point out that determining the distance to the stop-loss is only one half of the assessment when taking a position. One must also consider the potential on the upside. That is what you are looking for. A general rule many traders use is to look for a risk/reward of at least 3. This means that if you set a 0.65% stop after entry, you must envision at least a 1.95% upside in order to have a risk/reward above 3. In in the case of the S&P 500, the ATR (average true range = normal daily average movement) is approximately at this level. For an intraday trade, it takes a lot to capture all of this, and in the example the index has already been 0.65% lower. An intraday trade at such a level will probably not have satisfactory risk/reward. An overnight trade may have that, but one might not want to assign maximum risk (R1) to such a trade. Everything must be considered.

In general, one can say about position size:

• The more certain you are of a good case, the bigger the position you can take.
• The better timed entry you manage to get, the bigger position you can take.
• The more liquid the instrument, the larger the position that can be taken.
• The greater the fluctuations (volatility) in the instrument, the smaller the position.
• The higher the leverage used (in a trading instrument), the smaller the position.

Choosing the right position size is a very central part of the continuous risk management for a trader. A well-known expression from medical science is that the difference between poison and medicine depends mostly on the dosage. This is also the case with position sizes in trading, and no one can last long as a trader without being able to manage their risk well. From this comes the old trading quote:

      "There are old traders and bold traders but very few old, bold traders"

Disclaimer: After many years in the brokerage industry, in 2021 I published "Paleo Trading: How to trade like a Hunter-Gatherer” and launched a hedge fund that trades according to the principles described in the book. Vontobel asked if I would write posts for their blog, similar to what traders and managers do in other countries. It is emphasized that nothing written on this blog is to be regarded as personal advice or a concrete call to take positions. Everyone must be responsible for their own decisions and familiarize themselves with the products they use.