Buy low and sell high. Isn’t it what traders want to do all the time? Is it the ticket to serious riches? Unfortunately, that’s not what will make you a trader who can consistently remain profitable, thereby ensuring that you remain in the game long enough to become rich.What’s the holy grail then? It’s called risk management. In fact, the difference between successful traders and unsuccessful traders almost always boils down to this. And position sizing is the cornerstone of risk management.
So what is position sizing? It is a framework that essentially decides the average size of a position that you can take depending on the size of your trading capital and your risk appetite.
Imagine you have a capital of Rs 1,00,000. You come across a stock trading at Rs 1,000, which you think could go up.The first step to do proper position sizing will be to determine your stop loss level – the level at which you will exit the position should it run against you. Also, note that stop losses are determined using a scientific method and should never be a function of your gut feeling.
But back to the example at hand. You believe that the Rs 1,000 share could find support at Rs 980 should it go down, and hence choose it as your stop loss.
The second step in position sizing will be determine the maximum loss you can take on the trade should the trade go against you. Most experts, such as Market Wizards Author Jack Schwager among others, advise that you should not risk more than 1% of your capital on a single position. If you have a high risk appetite or have small trading capital, you increase this figure to 2%.But using the 1% rule in our above example, we can determine that the maximum we can lose on your trading position is Rs 1,000.
Since we have determined Rs 980 as the stop loss level (or a Rs 20 loss per share), we can determine that we can buy a total of 50 shares. This means that should your stop loss get hit, you will lose Rs 1,000.
If you consistently follow this rule, you have ensured that the chances of you blowing up your trading capital are small, as you will have to be wrong a straight 100 times.
There is another rule, which overrides the 1% rule: which is the number of open positions you can keep at any point. Most traders advise that you do not maintain any more than five positions at any one point. This means that you can allocate as much as 20% of your capital to any one position.
What this means is that, with your Rs 1 lakh capital, you can bet as much as Rs 20,000 on a single trade. Given that you can purchase only 20 shares of Rs 1,000, with Rs 20,000 capital, and not 50 (as we decided above), we will choose the more conservative rule of the two. This means that we will buy only 20 shares, and not 50.
Combining position sizing with the optimum risk-reward ratio ensures that you will come out ahead over the long term even if you are right only 50% of the times.
For instance, in the example above, if you chose to keep a risk reward ratio of 1:2, your target for the Rs 1,000 stock will be Rs 1,040, given that you kept at a Rs 20 stop loss.
This will ensure that you make more money on your winning trades and smaller losses on your losing trades! And that, my friends, is the holy grail of successful trading!
