In the previous lesson we introduced another important yet often overlooked aspect of trading and money management which is position sizing. In this lesson we are going to begin to look at some of the strategies that many successful traders use to determine their position sizes.
As we discussed briefly in the last lesson many traders make the mistake of choosing an arbitrary number such as 1 contract or 100 shares of stock to trade when they first enter the market. In addition to the fact that this does not consider the amount of capital a trader has at his disposal, it also does not take into account the fact that the Dollar value as well as the volatility characteristics of one contract or 100 shares of stock is going to vary greatly. Like a poker player who bets the same amount on every hand, this also does not allow a trader the flexibility to trade bigger on trades with a higher probability of success and smaller on trades with a lower probability of
As you can see from the picture below, a trader trading 100 shares of a $20 stock which fluctuates 5% a day and a second position of 100 shares of a $30 stock which fluctuates 1% a day does not present the risk/reward picture that many traders would expect it would. In this example the smaller position actually has a greater potential risk and reward because of the greater volatility of the first stock in the example.
The next level of sophistication up from the above, is trading a standard trade size such as 1 contract or 100 shares of stock for every fixed amount of money.
As Dr. Van K. Tharp points out however in his book Trade Your Way to FinancialFreedom, there are several distinct disadvantages to using this method which are:
- Not all Investments are alike (100 shares of a $10 stock which moves 5% a day is not going to be the same as trading 100 Shares of a $10 stock that moves 1% a day)
- It does not allow you to increase your exposure rapidly with small amounts of money
- You will always take a position even when the risk is too high.
As you can hopefully see from the above information, while the fixed position size per dollar amount is better than simply picking a number out of thin air, there are many disadvantages to this method. In the next lesson we’ll begin to look at some different ways of overcoming these disadvantages, starting with a discussion of the martingale and anti-martingale position sizing strategies.