Position sizing, along with stop losses, forms the two pillars of risk management, the most important skill needed in order to be a successful trader. I have already written about the art of setting stop loss points in the days of computer based algorithms designed to run over the usual stops. In fact, I have also already written a post on what makes position sizing so important, but this post is going to deal with how to decide what is the right position size for you.
A lot many trading books and blogs state that one should place 10% or 20% of one's capital in any single position and not more than that. According to me, all these percentage figures are useless as they assume a certain size of trading account. For example, some even recommend that a single position should never be more than 2% of the trading account. But if you have a small trading account like the one I started with, even a 20% position size would be so small that just the commissions would hurt your trading bottom line. (BTW, for those interested, here is the link to a series of posts I wrote about trading with small accounts). Hence, I am not going to give you any magic number or formula for what the perfect position size should be. But what I am going to tell you is a couple of points to consider for finding out what is the right position size for you.
Most of us when we start trading (I know I did!), choose a position size depending on the amount of reward we think we can get from that setup. If you think the potential reward is great, might as well go for a bigger position, right?? Wrong!! Absolutely wrong! Time goes by, one gets knocked down by the markets, and one realizes (hopefully!) that it is not the potential reward that should determine the position size, but the risk involved in the trade. Take care of the losses and the winners will take care of themselves. While amateurs take position sizes depending on the potential reward involved, professionals determine a position size depending on the potential risk involved. Each one has our own threshold of pain (read loss), that our trading account and we emotionally can stand. So, if I my stop loss is 1% away for a particular setup, I will consider taking twice the usual position size than say, if the stop loss was 2% away. Or if I like a position but want to give it more room to run (due to the set up or choppy overall market conditions), I will take a smaller than usual position size. It all depends on the absolute value of the loss that you and your trading account can take.
Here is another very easy to implement suggestion while considering the position size. Never hold a position so large that it affects your peace of mind! Lighten up when you think you are going to spend a sleepless night worrying about a particular position until you reach a position size/ loss limit that you are comfortable with. No amount of profit is worth it if it affects your family life or life beyond the trading hours.
Take care and good luck!
The art of setting stop loss points in the days of computer based algorithms designed to run over the usual stops.