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• Karen Wong

Optimising Position Size

There are many scenarios in life where low is better. Lower inflation, lower cholesterol and lower levels of stress. On the other side, a low tide is not so good for fishermen and of course a low balance is not so good in a portfolio. Without the skill of position sizing, portfolio balances may fall to a low faster than is comfortable. Position sizing helps manage potential losses, ensuring a healthy balance for taking the next trade.

Past conversations amongst traders and investors have revealed, surprisingly, many do not include position sizing in their trading plans, that is the act of calculating the optimal number of stocks to buy while taking into consideration the size of a portfolio.

The process of position sizing is based on the idea of capital at risk. Risk is the potential amount lost on a position should the trade fail. The amount of risk tolerance varies according to each individual and the value of the portfolio. Calculating the number of shares to buy provides a better idea of how much capital is actually at risk.

These are the steps I take in determining how many shares to buy for a particular stock.

1. RISK AMOUNT

Standard practice in good risk management advocates risking 1% to 2% of the total portfolio value. Let’s assume for this article, the portfolio value is \$100 000 and we choose to risk 1% for a particular trade.

Maximum Dollar Risk Per Trade is calculated as follows:

1% X \$100 000 = \$1000

If our trade doesn’t work out, we want to exit the trade at a maximum total loss of \$1000.

2. STOP LOSS

The next figure required in the calculation is the stop loss price. The stop loss I often use is the 2X ATR indicator. Sometimes it may correspond with a support/resistance level. The stop loss method is not the focus, knowing where your stop loss will be is.

3. CALCULATING RISK PER SHARE

Taking note of the current entry price, we subtract the stop loss price and the result is the risk per share.

Risk Per Share = Current Entry Price – Stop Loss

4. POSITION SIZING

Once we have the figures from steps 1 to 3, it is easy to work out the optimum number of shares for a position.

Position Size = Max \$ Risk per Trade

Risk per Share

Let’s apply this method to a past SYR trade. On the daily chart of SYR, Figure 1, we see a GMMA uptrend in place where the short-term GMMA is sitting above the long-term GMMA. The traders are active and supportive as the lines of the short-term GMMA are widely separated. Investors are also supportive. The long-term GMMA lines have twisted over and expanded out.

Figure 1

Preference is for this to be a longer-term trend trade opportunity. We open the longer timeframe weekly chart, Figure 2, for further analysis and a potential entry.

Figure 2

Analysis of the GMMA groups shows the short-term GMMA moved up through the long-term GMMA. The lines of the short-term group had turned over, moved up and began to separate. Price moved up from the second point of a bullish RSI divergence. The RSI indicator made a lower low while price made a slightly higher low. Taking into account the strongly supported trend on the daily chart, there was a high probability of further moves to the upside.

Before opening the trade, we want to know the optimal number of shares to buy in line with our risk tolerance. Let’s apply the above methodology described to work out how many shares we should buy for this trade.

1. RISK AMOUNT

Calculated as 1% of a \$100 000 portfolio value.

The maximum dollar risk on this trade is \$1000.

2. STOP LOSS

From the weekly chart, the stop loss is \$1.22 based on the 2X ATR indicator.

3. CALCULATING RISK PER SHARE

Current entry price of SYR is \$1.88.

Risk per Share = Current Entry Price – Stop Loss

= \$1.88 - \$1.22

= \$0.66

4. POSITION SIZING

This is the final step in working out the optimal number of shares to buy for a position taking into account our maximum dollar loss.

Position Size = Max \$ Risk per Trade

Risk per Share

= \$1000

0.66

= 1515

Based on this number, we bought 1515 shares at an entry price of \$1.88 with a stop loss at \$1.22 and a profit target of \$2.54.

For comparison, consider the trader who simply buys a position, for example 10 000 shares at an entry price of \$1.88. The maximum dollar risk given a stop loss of \$1.22 is calculated as follows:

No. of shares x Risk per share

= 10 000 x 0.66

= \$6600

This represents a 6.6% risk of the total \$100 000 portfolio. It will take 15 losing trades in a row to get to a zero balance, compared to a 1% risk where it will take 100 losing trades in a row to get to zero.

Figure 3

Continuing the story of the trade, price moved upwards after the initial entry then a retracement back down tested the long-term GMMA area before extending another leg in the uptrend. The ATR stop loss became a trailing profit stop loss, moving up as price moved up.

The profit target was met at \$2.54 and price continued on to a high of \$2.69. Greed played a part in not taking profit at the target and slowly the price dipped as did the accumulated profit. The trade position was closed at \$2.24 as marked by the yellow star.

Price continued to fall and the ATR stop loss indicator triggered an exit after price closed below \$1.88.

Good trading ends in profit. Not so good trading ends in a loss. Proper position sizing ensures a trader’s portfolio account does not fall to zero in a hurry when times in the market are bad. Manage risk and live to see many more trading days.

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