Position Sizing Fundamentals

Position sizing determines how much money to allocate to each investment. It's the most important risk management tool—more important than picking stocks. [DEFINITION] Position Sizing: The process of determining how many shares or what dollar amount to allocate to a single investment, based on account size and risk tolerance. ### Why Position Sizing Matters [KEY] Even with a 70% win rate, poor position sizing can lead to ruin. Conversely, proper position sizing can make a 50% win rate profitable. **Key principle:** No single trade should be able to significantly damage your portfolio. ### Common Position Sizing Methods **1. Fixed Dollar Amount:** Invest same dollar amount in each position ($5,000 per trade). - Simple - Doesn't account for volatility **2. Fixed Percentage of Portfolio:** Each position is X% of portfolio (5% per stock). - Limits concentration - Doesn't account for individual trade risk **3. Risk-Based Position Sizing (Recommended):** Size based on how much you're willing to lose. [FORMULA] Position Size = (Account × Risk %) ÷ (Entry - Stop) [EXAMPLE] Account: $100,000 Risk per trade: 1% = $1,000 Entry: $50 Stop: $45 (risk $5/share) Position size: $1,000 ÷ $5 = 200 shares ($10,000 position) ### The 1-2% Rule **Never risk more than 1-2% of your account on a single trade.** Why this works: - 10 consecutive losses = 10-20% drawdown (recoverable) - Allows for inevitable losing streaks - Preserves capital for future opportunities [TIP] Professional traders often risk less than 1%. Beginners should start with 0.5% per trade until consistent. ### Volatility-Adjusted Position Sizing Use ATR to size based on stock volatility: [FORMULA] Position Size = (Account × Risk %) ÷ (ATR × Multiplier) [EXAMPLE] Account: $100,000 Risk: 1% = $1,000 Stock ATR: $3 Multiplier: 2 Position size: $1,000 ÷ ($3 × 2) = $1,000 ÷ $6 = 166 shares ### Pyramid Strategies **Adding to winners (pyramiding):** - Start with partial position - Add as trade moves in your favor - Never add to losers [EXAMPLE] Initial: 100 shares at $50 After move to $55: Add 50 shares After move to $60: Add 25 shares Average cost: $53.14 with smaller additions as price rises. [WARNING] Never add to losing positions hoping they'll recover. This is the path to large losses. ### Maximum Position Limits Additional rules beyond per-trade risk: - Maximum position: 10% of portfolio - Maximum sector exposure: 25% - Maximum correlated positions: 40% [EXERCISE] You have a $50,000 account and want to risk 2% per trade. You're looking at a stock at $30 with a stop at $27. What's your position size in shares and dollars? |ANSWER| Risk allowed = $50,000 × 2% = $1,000. Per share risk = $30 - $27 = $3. Shares = $1,000 ÷ $3 = 333 shares. Dollar position = 333 × $30 = $10,000 (20% of account). [SCENARIO] You've calculated that you should buy 200 shares based on your position sizing formula. But you feel really confident about this trade and want to buy 500 shares. Should you? No. Confidence is a feeling, not an edge. Your position sizing rules exist precisely for moments like this—when emotions try to override logic. Every trader who has blown up their account thought they were "really confident" on the trade that destroyed them. Follow your rules.