This article is submitted by Michael Toma.
Michael is a Certified Risk Manager, author of The Risk of Trading: Mastering the Most Important Element in Financial Speculation, trader, and our “resident risk” contributor.
If there is one topic within the risk management space that I get lots of questions on is that of position sizing. I agree; it’s most often misunderstood or at least the most difficult to maintain a level of discipline.
Personally, I take a very data-driven approach and it does require some results tracking from my journal to help with my position sizing.
In a recent interview, I posed the argument of why anyone would start their trading journey with anything but a ‘1-lot’, 100 shares or similar and let the results allow for increases in position size. In essence, what is the difference if you make $50 on a trade or $1,000?
The most common answers are:
Q: If I’m doing very well and consistently successful, why don’t I increase size?
Answer: The graduation plan noted below will get you there. Just be a little patient.
Q: Well, what if I need to make more to pay my bills?
Answer: Big trouble! The market doesn’t care about your expenses and trade journal audits often show a trader will ‘press’ their trades, particularly after losing trades.
Here is a concept however that requires relatively little effort and takes the guesswork out of position size:
One can use percentage-of-account formulas that factor in trade size vs. position size but I often preach that account size should have very little weight in the equation. Even worse is using the brokerage firm’s buying power to determine position size. So why shouldn’t one with a $1 million dollar account size start at the same position level as the $20k account?
I agree it’s a bit controversial but I love the friendly debate with me using the trader experience level as the absent component from the prior percent-based equation.
In other words, isn’t it more probable that an inexperienced trader with a big account will make more errors than an experienced trader with a smaller but growing account? So why do most position size formulas not factor in the experience level?
One solution is to have both traders start out of same gate yet the larger account can ‘graduate’ to higher levels more quickly if showing they are executing their trades effectively. For instance, if you are measuring winning trades, net points or similar, A $20k account can graduate to the next buying level after, say, a net +20 wins where a much larger account can be allowed to ‘fast-track’ graduate after a +5 or +10 wins. In my opinion, that is a much better risk-based solution.
Either way, you will ultimately get to your ideal position size and allow you to experience any graduation fears as you add size to your trades.
Another risk control based method can be to delegate the risk management, particularly position size limits, to a 3rd party. With one of my trading clients, he granted me authorization with his broker to allow an increase in position size on his account when his results triggered the ok to increase. It also lent risk oversight which virtually eliminated impulse trades. As a result, plan compliance went up, he graduated at a more consistent pace and eventually was happier that he was reaping more profit rewards for his efforts.
Give these ideas some thought if you are using a pure percentage-based formula or using arbitrary trade setup strength to determine how much size you place on a trade.