Benefits of Position Sizing

The recent financial markets have been tough, to say the least. Some things that worked the first part of the year stopped working weeks later. Other segments of the market have experienced tough sledding for a year or longer. In summary, it has been hard to gain any traction with a lot of your investments.

But we must play the hand we are dealt. Right now that hand is one that offers short-term (and sometimes fleeting) gains. In other words, there are small pockets or sectors where things are working, but our time horizon needs to be adjusted. We can no longer focus on the intermediate or long term rather we must focus on shorter term trading moves to grow your balances.

The most important aspect of any portfolio has always been position sizing, but it is crucial in this environment. Once we decide to buy a stock or ETF, we need to establish three control parameters entry price, position size and a logical point to exit the position if the trade goes against us. Does this really matter? Absolutely. Without properly assessing these three parameters upfront, we have no way of minimizing position risk while maximizing the account value. So today I wanted to go over my preferred method for sizing positions. It’s called the Percent Risk Method, and it works for trading accounts and longer term investment accounts.

The Percent Risk Method

First, we look only at positions that fit our risk-based criteria using Point and Figure charting. Let’s say you have a $500,000 investment or retirement account. Depending on the type of market we are in, we would choose position sizes ranging from 1⁄2% to 2% of your total portfolio value. As an example, let’s say we agree to use a 1% risk tolerance per position in your account. This means that each position will be sized so that the risk to your overall portfolio is no more than 1% of your $500,000 account. One percent of $500,000 is $5,000; so that will be our risk for the first position.

So let’s now approach that single position based on our calculated risk. In this example we will use our old favorite XYZ. Since we know (or can determine) our stop loss point for our trade in stock XYZ, we would determine the distance from our entry point to our stop loss point (risk to stop), and then divide that into our $5,000 risk for the position. The resulting value will be the number of shares that we can purchase to stay within our 1% risk tolerance.

Here’s an example: XYZ is trading at $49 on its trend chart, and we determined that this is a reasonable investment to consider. We have a pattern that would suggest exiting at $45. Our entry price would be $49, and our risk on this trade is $4 ($49-$45, our stop).

We now divide our $5,000 risk for this position by our $4 risk per share to give us a position size of 1250 shares. So if we buy 1250 shares of XYZ, and get stopped out with a $4 loss, you would lose $5,000 – which was your original risk tolerance for this. Naturally, as the distance to your stop loss point decreases, your share size will increase; conversely, the opposite will occur when you are considering stocks trading further from your stop point — the number of shares purchased decreases.

So again, with the percent risk model that we used, the most that is ever risked per trade is 1% of the account value at the time the trade is made. (So you mark the account to market each day before you can figure out what the 1% risk would be for any subsequent trades.) The main rule to adhere to with this method is that you must respect your stop points. Remember, your position is sized as a function of the risk to the stop point. So if your stop point is hit, you must stop out, or obviously will risk losing more that the previously decided 1%.

But the beauty of the percent risk method of position sizing is how much it can enhance your returns. If you have a large position in an individual security (and therefore the stop point will be tight), and that trade works out in your favor, it will add considerable money to the bottom line vis-à-vis a smaller position, all while risking the same as any other trade.

Another fundamental benefit of this approach is that it helps us deal with emotions. The Percent Risk model takes some of the emotional influence out of the process by forcing you to make smaller ‘bets’ when the market dictates, and forcing you to make sequentially equivalent bets on each trade. When the market is on offense, we would typically suggest taking a 1% position in every trade, regardless of how bullish your emotions are telling you should be on any single trade. This keeps any single position from beating you, and allows for the trading system to work based upon its own merit. Finally, the often-difficult, emotion-ridden decision of when to sell has been pre-determined when you go into the trade. The key, though, is to adhere to your pre-determined stop.