One of the most important aspects that you must pay attention to when trading in the financial markets is position sizing. Entering into a trade with the right position size could potentially increase the chances of success of your trading strategy. Understanding the concept and its importance can help you manage risk more effectively and maximise your returns.
What is position sizing?
Position sizing refers to the maximum number of units of an asset that you can purchase in a particular trade. The primary objective of position sizing is to minimise the losses you suffer from trades while simultaneously attempting to maximise the profits. It is one of the most important risk management strategies that every trader must be aware of.
Understanding position sizing
To fully appreciate the concept of position sizing, you must first understand two concepts - account risk and trade risk. Here is a quick overview of what they are.
Account Risk
Account risk refers to the maximum percentage of trading capital that you are willing to risk on a particular trade. It is usually determined based on factors such as your risk tolerance level and the trading strategy you intend to use.
For example, a conservative trader attempting BTST trades may be willing to risk only around 2% of their total trading capital on a single trade, whereas a more risk-aggressive trader may be open to risk up to 5% of their total trading capital on a trade.
The entire point of account risk is to make sure that you do not lose a large portion of your capital, even if one or a few trades go against you. By setting the right account risk level, you can limit the negative impact that an unfavourable trade can have on your capital and ensure that you are in a position to continue trading even after a series of losing trades.
Trade risk
Trade risk is the other key concept of position sizing that you need to be aware of. It refers to the maximum amount of capital that you are willing to risk on a particular trade. The trade risk is the difference between the price at which you enter into a trade and the stop-loss price of that trade.
For instance, let us assume that you are into share trading and that you wish to trade the stock of a company that is on a bullish uptrend. The current market price of the stock is Rs. 1,500 per share. To protect yourself from potential downsides, you set a stop-loss point for the trade at Rs. 1,450 per share. In this case, your trade risk would be Rs. 50 per share (Rs. 1,500 - Rs. 1,450).
Also read: What is a block trade?
Formula for determining position size for a trade
Now that you have understood the two key concepts of position sizing, let us look at the position size formula that traders often use.
Position size = Account risk ÷ Trade risk
To determine the ideal position size for a trade, traders often consider both the account risk and the trade risk. Here is a hypothetical example highlighting how the position size for a trade is arrived at.
Assume that you wish to trade in the stock of a company. Your total trading capital is Rs. 5,00,000. Since you are a conservative trader with a low tolerance for risk, you set the maximum account risk at 1% of your total trading capital. This effectively means that you are willing to risk up to Rs. 5,000 (Rs. 5,00,000 x 1%) on a particular trade.
Now, the current market price of the stock is Rs. 780, which is also the price at which you plan to enter into the trade. To protect yourself from potential losses due to adverse market movements, you set the stop loss at Rs. 730. This means that your trade risk would be Rs. 50 (Rs. 780 - Rs. 730).
If you substitute both the account risk and the trade risk values in the above-mentioned formula, you will be able to determine the ideal position size for this particular trade, which is as follows.
Position size = 100 (Rs. 5,000 ÷ Rs. 50)
This essentially means that the ideal position size for this trade must not be more than 100 shares of the company. Opting for a larger position size (more than 100 shares) increases the risk you take on a trade. On the other hand, choosing a smaller position size (fewer than 100 shares) reduces the profits you could potentially get from a trade.
Conclusion
Position sizing is an important factor that you must consider when entering into any kind of trade. It allows you to effectively manage risk and protect your capital without negatively impacting the profit-generation potential of a trade.
That said, as a trader, you must regularly review and adjust your position-sizing strategy based on the prevailing market conditions. For example, if the markets are very volatile, you could consider risking a lower percentage of your trading capital and setting tighter stop losses. Although this would lower your position size for a trade, it can potentially insulate you from adverse market movements.
Similarly, if the markets are not volatile and have a clear uptrend or downtrend, you may choose to risk a greater portion of your trading capital and set wider stop losses to boost the return generation potential of your trade.
