Position Sizing

This post is from a very savy trader I know that is showing me the ropes with diagonal spreads. His online trading journal can be found at http://www.insanemoney.com. Position Sizing has saved me so I want to share this with you as it can save your portfolio as well. Read below...

"Help with Position Sizing"

Mojo

8:46am, November 30, 2007

I put together my thoughts on position sizing and would like to your feedback. Here it is:

If there is one thing I would say that has made the most significant difference in my success and stress level as a trader I would say "Position Sizing". What is position sizing? Its determining the maximum number of contracts allowed per trade based against your total portfolio size. Why is this important? Because it determines how many losing trades in a row your portfolio could stand before you lose everything. Professional gamblers call this your "risk of ruin". Remember your job is not to make money, but to protect your capital and extract the most experience out every dollar.

Here's a simplistic example. Let's say your portfolio is 100K. We will flip a coin 100 times with heads representing a "win" and tails representing a "loss". This gives you a 50/50 chance for each trade. Here are the results:

WLWLLLWWLLLLLLWWLLWWLWLWLWWWWLLLWLWLWLLLLWWLLLLWWL LWLWLLWWLWWLLLWLWLLLLLLLLLWWLWLLLWLWWWLLWLWLLWLWLL

Notice that in this random sample there are several consecutive wins (heads) and losses (tails). These streaks are completely normal and expected in a random sample. These streaks are where your position sizing becomes important. In trading there is something called "surviver bias". Basically its the idea that only the profitable traders survive and only those traders that survive the first three years will be profitable over their entire trading career.

If you are risking 20% on each trade and you have 2 losses in a row your portfolio will be down 40%. Mentally, are you prepared to hold the faith and stick to your trading rules once you've wiped out 40% of your account? Most people aren't (including me!). How would your wife or husband feel about a 40% loss? Would they continue to support your trading? Remember, we are trading to make our lives work for ourselves and for everyone around us.

Since most people's pain threshold is no more than a 40% loss, let's look at how many trades it will take to get us to quit trading and end our trading career.

If you are risking 15% per trade it will take 3 losing trades in a row to generate a 45% loss.
If you are risking 10% per trade it will take 4 losing trades in a row to generate a 40% loss.
If you are risking 7.5% per trade it will take 6 losing trades in a row to generate a 42% loss.
If you are risking 5% per trade it will take 8 losing trades in a row to generate a 40% loss.

At this point you might think "That's impossible, I will never have 8 losing trades in a row!". Well, look at the random sample (line 2). There's a losing streak of 9 loses in a row. Ask any trader with sufficient experience and they will tell you that this is not only possible, but even likely to occur.

If you are risking 2% per trade it will take 20 losing trades in a row to generate a 40% loss.
If you are risking 1% per trade it will take 40 losing trades in a row to generate a 40% loss.

Does this make sense? Yes? OK, good. What percentages do I use? I use the following percentages based on the underlying security (stocks vs. industry ETFs vs broad based ETFs) and the type of trade. These are hard fought rules that I'm constantly refining so I'm always open to feedback.

Single Stock (XOM) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Industry ETF (XLE) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Broad Based ETF (SPY) + WOTM Vertical Spread <= 5% [limited news risk, stop loss at 3x initial credit]

Single Stock (XOM) + Put Calendar <= 4% [stocks crash down not up, good salvage value on long puts (50% or better)]
Industry ETF (XLE) + Put Calendar <= 5% [industries crash down not up, good salvage value on long puts (50% or better)]
Broad Based ETF (SPY) + Put Calendar <= 10% [markets crash down not up, good salvage value on long puts (50% or better)]

Single Stock (XOM) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Industry ETF (XLE) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Broad Based ETF (SPY) + Diagonal <= 3% [use a 20% stop loss so your initial position is up to 15%]

Single Stock (XOM) + Iron Condor <= 0% [I don't do Iron Condors on individual stocks, too much event risk]
Industry ETF (XLE) + Iron Condors <= 2% [use a stop loss of 3x initial credit]
Broad Based ETF (SPY) + Iron Condors <= 5% [use a stop loss of 3x initial credit]

Remember, our goal is to reduce all risk we can and mitigate everything else. Position sizing is one of the "free lunches" we get so take advantage of it.

Mojo

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