Master Position Sizing in Trading: Essential Formulas and Strategies | Enlightened Stock Trading (2024)

So you’re finally ready to start trading and then the unexpected happens…

Your account blows up super quickly within the first few months and you don’t understand why this happened. One of the biggest causes of this early blow-up is an incorrect approach to position sizing in trading.

Position sizing is a frequently neglected topic when you learn stock trading and is particularly dangerous when you’re just starting out. This article will ensure that doesn’t happen to you!

Calculating position size consistently across all of your trades will stabilise your account and normalise your risk so you don’t get killed if one of your stock trades goes bad. In this video, I explain how to calculate position size so you are consistent across all of your positions.

What is Position Size in Trading?

In this article, you’ll learn everything you need to know about position sizing in your trading. You’ll learn why position sizing meaning is important, the best position sizing models and how to implement them.

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Many ask if there’s a position sizing algorithm to follow. That’s why in this article, I’ll share how to calculate your position size for any trades that you want to make, one of the most important lessons when you learn stock trading.

The first thing to look at before taking any trade is understanding the risk per share or per contract. That way you know on what basis to size your positions. For instance, let’s say you’re going to take a trade in this instrument and this bar here is your entry bar. Identify that we get an entry signal right here at a price of $3.48, for example.

The first thing to do is set your stop-loss according to your stock trading system rules.

That could be volatility-based or chart-based. This stop-loss here is based on a certain multiple of the volatility of the average true range (there’s any number of ways you can do that).

We’ve got an entry price of $3.48 and we’ve got an initial stop loss on this share of $3.25. That gives us a total risk per share of 23 cents. If you’re wrong on this trade and we have 1 share, your loss will be 23 cents. your job now is to figure out how many shares we should buy given this risk per share of 23 cents and the size of your account.

There are many position sizing techniques, but I’ll teach you the basic formula you need to know to make sensible choices.

Here’s how to calculate position size in trading by using a simple formula:
The number of units that you buy is equal to the equity that you have in your account multiplied by the risk per trade that you want to take, divided by the risk per unit.

Equity is the total amount of money in your account.

Multiplied by risk per trade, you might be risking say 1% of your account on each stock trade. That means if you’re wrong, you’ll lose 1% of your equity on this trade. Divide that by the risk-per-unit (which was calculated on the previous slide) to determine how many total units you can buy.

This ensures that all trade sizes are adjusted so that the positions give the same dollar risk portrayed.

What you want to avoid as a trader is inconsistency, such as having a $500 loss on one trade, a $3,000 loss on another, a $10,000 loss on another, and a $2,000 loss on another because you’ve got different position sizes all over the place.

One of the first steps towards consistency when you learn stock trading is standardizing your position size so that if you’re wrong, you’ll lose the same amount on each trade.

You get much greater consistency of returns and a sense of confidence because you know how much you’ll lose when you’re wrong and how much that’ll impact your account. You can then start to manage your risk more successfully.

It also gives your trades the same dollar profit potential. If you size your trades based on a volatility stop-loss, each of your trades has an equal chance for success or failure.

For instance, if you buy a $50,000 position in Facebook and a $2,000 position in Apple, then the Facebook position is going to have a much higher level of risk and a much higher potential for dollar profit than the Apple position. With the Position Size limit formula, you can standardize the amount of profit and loss potential on each of your trades.

Let’s take an example using the same chart that we talked about before. Let’s assume you have $10,000 of equity and you want to risk 1% per trade. How does that calculation work?

The number of units is equal to the $10,000 of equity multiplied by your 1% risk, divided by the 23 cents risk-per-unit or per-share that we calculate. (Ignoring commissions for simplicity, add in commissions to make it a bit more realistic later.) That equals a $100 ris- per-trade. That’s your $1,000 equity multiplied by 1 %; Divided by 23 cents per share, per unit. That’s total of 434 units that you’re allowed to buy in order to risk 1%.

On that previous chart if you took that trade, you bought 434 units. If your initial stop was hit and you got out, you’d be losing only $100 (1% of your $10,000 account).

So you can risk a small amount of your account on each trade for a buffer, allowing you to be wrong many times in a row. For example, let’s say you want to risk only a small percent of your account on each trade, less than 1%.

If you’re wrong several times in a row, you won’t lose too much money. Remember, success in the beginning of stock trading is about avoiding significant losses as much or even more than it is about making significant gains.

If you’re wrong only one time and you risked 10% of your account, then you’re already down to 90% of the original. From $100 that leaves you at $90.

If you take a second trade and we lose, then you’re already down to 80 or so. By the time you take 10 losing trades in a row (risking 10% of your account on each trade) then you’re already down to $34 from your starting point of $100.

Based on that, risking 10% of your account on each trade is way too much.

Let’s have a look at some other examples. If we risk 5% of your account on each trade and you get 10 losing trades in a row, then you’re down to about $59/$60 at the end of that.

If you risk only 1% and we have 10 losing trades in a row, then you’re down to $90. If you risk only half a percent, then after 10 trades you’re down to only $95.

So what you can see is that the smaller amount you risk per trade, the more losing trades you can have in a row without badly damaging your account. I would certainly advocate for most people to consider risking less than what you already are. If you’re risking in the vicinity of 5 or 10%, chances are you’re risking way too much money on each trade.

Take a good look at how many losing trades you can potentially get in a row and consider reducing your risk so that you’re not damaging your account if you get a string of losing trades.

You might think, “10 losing trades in a row, who would be so stupid as to lose that much money?” If you’re a trend follower, then you’ll probably make your money on a small number of trades, and have a large number of small losing trades.

Let’s say you try the trend following system like I do, you might be right 30% of the time and wrong 70% of the time. That sounds pretty bad, except when you realize that when I’m wrong, maybe I lose $1,000. But when I’m right, I make $10,000.

When the size of the losses is a lot smaller compared to the size of the gains, you can actually afford to have quite a low reliability or a lot of losing trades.

If you’ve get only 30% winning trades and 70% losing trades, you can actually get a very long losing streak and that’s why I highly suggest that you risk a small percentage of your account on each trade.

What if you get a big loss or a drawdown in your account? Check out this example in the photo. You’ll first see a level of drawdown and then in the next column how much return you have to make in order to recover your initial account size.

Big drawdowns are particularly scary when you’re learning stock trading, so this is something you’ll want to understand!

Let’s say you have a drawdown, you lose 10% of your account so you started at $10,000, you lose 10%; You’re now down to $9,000. In order to get back to your initial $10,000, you need to make 11% because of the asymmetry of returns. Losing 10% means you have to make 11% back. That’s pretty similar so that’s not such a big deal, but when you start to get bigger and bigger drawdowns, this becomes more and more of a problem.

Say you get a drawdown of 40%. You start at $10,000 and your account drops to $6,000. In order to get back to your original $10,000, you now need to make a 67% return. That becomes a huge challenge to break even and then going on to make a profit.

If you lose half your account (from $10,000 down to $5,000) you then need to double your money from $5,000 back up to $10,000. That means you need to get a 100% return just to break even.

You can see that the biggest challenge or the biggest driver of success in trading is going to be limiting your drawdown so that when you go on to make more money, you don’t have to make excessively higher returns to get back to where you started.

You should always be aiming to keep your drawdown in a low range because that way you can very easily go on to make new account highs. If you’re having big drawdowns like 40 to 70% or more, then it’s almost impossible to get back to where you started.

That makes it very difficult to make money trading in the long run.

When you learn stock trading, it is so easy to underestimate the risk you are taking on in each and every trade – I mean, after all, you are using stop losses…

(Seriously though, you are using stop losses, aren’t you?)

The trouble is that sometimes something unexpected happens and stop losses can’t always save you.

Like the time earlier this year when a position I was in dropped 47% overnight and was immediately suspended from trading. I have no idea how much I will lose on the trade, but it doesn’t matter because I followed the advice I am giving you in the video below.

In this video, I explain why risk management is so important and why you should risk only a very small percentage of your account on each trade. I hope you enjoy it!

This is particularly important when you’re learning stock trading using a system as a long-term trend following system with a large number of small losing trades to a small number of large winners.

In this photo you’ll see the trade distribution profile of a typical trend following system. The particular details of the system don’t matter, but basically in any trend following system that you use (any system that cuts losses short and lets profits run) you’re going to get a profile of trades like this one.

The worst trade outcome means we can’t risk too much on ANY trade.

You’ll see on the right-hand side a small number of very large winners. This is where the bulk of your profits come from.

Then, you have a larger number of small winners. These are the ones that really help you break even.

Then, you’ve got a large number of small losses. These are the things that chip away at your account. And this is where you’re going to manage your risk day today.

Now, the key thing that you can notice if you look carefully here on the very left-hand side is the worst single trade in this entire backtest, a loss of 5.1 multiplied by the intended risk.
What this chart represents is the number of trades on the left-hand column, and the R-multiple.

If you intended to risk $1,000 dollars, and you won $2,000, then your R-multiple is 2.

If you intended to risk $1,000, and you lost $1,000, then the R-multiple would be -1.

This losing trade over here on the very left-hand side lost 5.1 multiplied by the maximum intended risk. Now, that’s one trade out of probably thousands on this chart. If that one trade existed in the backtest, then chances are that one trade, or worse, could also exist in the future in your system.

Now, when you’re managing your risk for a trading system, make sure that your system will survive and that you can profit regardless of what the market throws at you in the future.

The fact is, a -5 R-multiple trade that existed in the past could come back and bite you in the future. Make sure that the risk-per-trade you take on takes into account the worst trade in your backtest. Ensuring that your account survives the worst expected trade (and then some) is an important step to take early as you learn stock trading.

As an example: if you risked 2% on each trade that you took using this system and that trade came along this 5R loss, then your entire account would have been down by 10.2% just because of that one trade.

Now I don’t know about you, but I want to make sure that my account isn’t so sensitive or volatile to any one trade outcome. A single trade losing 10.2% (especially when I know that trade is there in the backtest and therefore potentially might come along again in the future) is simply an unacceptable risk.

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(2% Is Way Too Much Risk!)

When you look at your trade distribution profile like this in terms of R-multiples, you need to make sure that you’re comfortable with the amount that you’re risking and what that’ll translate to in terms of the worst possible loss.

This is why I teach people that (when doing trend following trading) to risk much less than 2% per trade.

A lot of authors and educators out there talk about the 2% rule and the reason people talk about risking no more than 2% is not that it’s the right amount across the board for everyone. It’s actually because if an educator talks to someone and says, “You should risk .2% of your account on each trade,” most people will be like, “You’re on drugs because how can you possibly make any money risking so little?”

The reality is that most people don’t have a clue how to make good consistent profits in the market.

And most people don’t understand how to stop themselves from blowing up when the market turns against them. 2% is a very rough and actually quite aggressive guidance for stop people from doing really crazy things like risking 5 or 10% of their account on each trade.

The other thing to keep in mind, though, is that while this trading system example generated a -5 R-multiple loss, the worst-case trade is often far bigger than the -5R that we see here. I’ve seen trading systems (some that I’ve tested and played with) where the worst-case loss was -10, -20. You don’t get very many of those, but you’ve got to be very careful with how you position size, in case those sorts of things come along.

What drives the very big R-multiple losses in many cases is a really tight stop-loss. If you’re using a tight stop-loss and you get a gap down or a gap against your position, you run the risk of getting big R-multiple losses.

As my accounts grow and as I’ve adjusted my risk profile to be a little more conservative, I started to use slightly wider stop losses and also smaller and smaller position sizing for each trade. That’s enabled me to have the confidence that I’m not going to lose big money when a bad trade comes along.

I hope that’s been useful and I look forward to seeing your questions and comments in the video stream below.

Let’s talk about how and why I use different position sizing models in my systems. This is a helpful discussion because I want you thinking about how to best assemble your portfolio of trading systems and the upsides and downsides of different position sizing models for each type of system.

You should never take any system your get at face value and assume the rules and position size calculation method used are the best or the only way to do implement the system. This is particularly with position sizing. So you need to know what position sizing methods are available for stock trading systems and crypto trading systems and when you should use each of them.

When you’re doing position sizing, there’s a couple of different general models:

• Percent of Equity Position Sizing
• Percent Risk Position Sizing
• Volatility Based Position Sizing

Our Position Size Calculator can do the heavy lifting for you for each of these three position sizing models. Click here to try it out today!

Percent of equity position sizing is where you take a certain percentage of that capital for each position and allocate that to each trade.

For example, assume you are using a 5% of equity position sizing model, and you’ve got $100,000.00 allocated to the system, the next trade is $5,000.00. How many shares of stock do you buy? $5,000.00 divided by the share price, it gives you the number of shares you buy.

Percent risk position sizing is where you normalize the initial risk on each new trade to a certain percentage of your account. The initial risk is defined as the difference between your entry price and your stop loss.

Once you know the difference between your target entry price and stop loss, you calculate the number of shares required to ensure that your potential loss is a certain percentage of your account.

For example, assume you are using a 1% risk per trade position sizing model, and you’ve got $100,000 allocated to the trading system. The risk you want to take on the next trade is 1% of $100,000 or $1,000. If your target entry price is $20/share and your stop loss is at $18/share then your risk is $2 per share. Dividing our dollar risk for the trade of $1,000 by our risk per share of $2/share tells us we can buy 500 shares.

A good general principle to keep you safe is to keep your risk per trade at 1% or less. Some people might think that you will never make money risking so little… but the reality is you will probably not survive if you are risking more than that in the long run.

Volatility-based position sizing is where you normalize the dollar volatility of all of the trades you take. For example, you might want one volatility unit to equate to 1% of my account. It’s somewhat similar to percent risk-based, but risk-based position sizing you can only do when you have a stop-loss in your system. If you don’t have a stop-loss, you can’t do risk-based position sizing. However, if you want to normalize the amount and dollar volatility of each trade, then you do volatility-based position sizing.

To do this you need a measure of volatility that you can use, and one of the best measures of volatility is the Average True Range (ATR). There are others you could use, but I generally use ATR for volatility based position sizing.

For example, let’s say you want to equate one ATR to 0.5% percent of your account, so on average each position you hold will only fluctuate by 0.5% of the value of your account each day. Let’s say you have the same $100,000 account and 0.5% volatility based position sizing model. The stock you are buying has an Average True Range of $1.50/share.

The dollar fluctuation you are targeting is $100,000 x 0.5% = $500. The ATR of the stock you are trading is $1.50, so you can afford to buy $500/$1.5 = 333 shares (to the nearest whole number of shares).

The volatility percent of your account you should use varies widely by system, so you need to backtest your trading system with different levels to decide what’s right for you – given your drawdown tolerance and objectives.

The overriding principle you should adopt is to test each position sizing model with each trading system to make sure that it works and best meets your objectives

You can be shown a ‘perfect’ system, but the wrong position sizing model for you could sub-optimize it. The right position sizing model could make you super profitable and consistent.

The advantages of the percentage of equity and position sizing are that:

1. It’s very simple and easy to do
2. Your trades have the same exposure

If the dollar exposure to each position in your portfolio in the system is the same, the catastrophic risk is normalized across all positions. Normalizing catastrophic risk is important because if you’ve got a $5,000 position, $15,000 position, $2,000 position, and a $20,000 position and one of those stocks goes bankrupt or gaps down 50% overnight, that could be a real problem for the big holdings. If it’s one of the smallholdings, it doesn’t matter.

Percent of equity position sizing normalizes catastrophic risk across all positions so you never really have to worry too much about getting hurt by an extreme adverse event in one stock.

It’s important to use percent of equity position sizing where there’s a chance that you could get hurt by one of your positions. Shorting stocks is a good example of this. If you did risk-based position sizing or volatility-based position sizing, you’d have some big positions and some small positions. Some of those positions could move against you if you’re short. If it’s a big position working against you, that could lose a lot of money. If you’re in a small position that moves in your favor you won’t make much money. This is a terrible dynamic.

However, if everything is normalized and one position moves against you while the other position moves in your favor they’re much more likely to balance each other out.

Another area that the percent of equity position sizing is good is if you have a tight stop-loss. The tighter your stop-loss, the greater the chance that there’s going to be a gap through your stop loss. If you’re holding a $10 stock, and your stop-loss is at $9.90, it’s only 10 cents if the daily volatility is relatively high. If something happens, it could gap down. But the wider your stop-loss, the gap has to be bigger to make the excess loss significant.

The tighter the stop-loss, the bigger the gap could be significant compared to your intended loss. But the wider stop-loss, the gap has to be huge for the excess loss to be significant.

If you have a tight stop-loss with percent risk position sizing and it gaps against you, you’re in real trouble. In this situation, you’re going to have a big position going against you, losing more money than you anticipated. When you have a relatively tight stop-loss system, the percent of equity position sizing is best because normalized exposure on each position reduces this gap risk.

Percent risk position sizing models are perfect for systems that trade a broad range of stocks with very different volatility levels like a long-term trend following system. For example: You’ve got stocks in IBM and Tesla. IBM doesn’t move around that much. Tesla jumps around all over the place and moves very quickly. So a percent risk position sizing model where the stop-loss is linked to the volatility of the stock means the more volatile the stock, the wider the stop-loss and the smaller the position size.

In that situation, the day-to-day movements in your account and the risk on each trade are normalized.

Percent risk position sizing is usually great for trend following as long as your stop-loss is not tight. If your stop-loss is tight, you’re going to end up with a high chance of big gap risk.

For a trend following system with a wide initial stop-loss, percent risk position sizing is quite good. The percent volatility and percent of equity position sizing model are helpful if you don’t have a stop-loss and want to normalize your account’s movements.

Use percent of equity position sizing is best when there’s a high risk of a catastrophic move against you, hurting you in a single stock, particularly with short positions or with tight stop-losses.

Use percent risk position sizing on the long side when you have a fairly wide stop loss in a trend following system.

Use percent volatility position sizing as a backup when you don’t have a stop-loss, but I want to normalize the dollar fluctuations across your trades.

There is a hybrid option, which is nice when combining the percent risk and the percent equity. So you can position size, half a percent risk per trade, but cap exposure on any one stock at 10% or 5%. This is a useful approach because sometimes with a percent-risk model (particularly if you’ve got a stop-loss which is volatility linked) your risk-based position sizing will give you a huge position size. This presents an unacceptable stock-specific catastrophic risk, so you also add a percent of equity cap of 5% to control this risk.

For example: if you have a $100,000 account and you’re risking 0.5% of equity per trade. Your entry price is $20 and the stock has traded in a tight range recently so the ATR-based stop loss is only $0.50/share wide. The risk-based position size model would tell you to buy how many shares? $100,000 x 0.5% / $0.50 = 1,000 shares = $20,000 exposure on this $20 stock… That is TOO MUCH EXPOSURE!!!

So if you also add the 5% of equity cap, your position size would be capped at $5,000 (250 shares) on this trade, so the catastrophic stock risk is much reduced compared to risk-based position size alone.

If you combine the risk-based position sizing model and the percent of equity position sizing model like this you get the best of both worlds. Your percent risk model gives you your day-to-day general returns and drawdown profile you’re comfortable with. However, the percent of equity cap limits your catastrophic risk to a level that you’re comfortable with.

You may or may not see the benefit of that in the backtest, but you do want to think about your risk management beyond what you see in the backtest, which is why the percent of equity cap is useful.

So, there are 3 models to choose from and if you’re building a system, I suggest starting with a 5% of equity position sizing model and then test the others from there. And I would always suggest you do all three when you’re playing with new system ideas and see which one works best for you.

I don’t use the same position sizing model or amount for all my systems because each system has its own model that’s finetuned to the rules of the system through backtesting and optimization (I do this using Amibroker).

If you really want to keep things simple, you could potentially use one position sizing model across the whole portfolio.

For example, a percent of equity position sizing model would normalize the catastrophic risk across every stock. That could be a sensible strategy, but you want to check if it would work well with each underlying system. Does it combine well into the portfolio?

Design the position sizing model specifically for each trading system and then combine those systems into a portfolio of systems with some diversity.

If you’d like to learn how to trade systematically and build a diversified portfolio of trading systems (including portfolio position sizing) that incorporate all of the risk management and position sizing considerations discussed in this article, then you should join The Trader Success System today and experience an acceleration towards your trading goals!

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