Money Management and Position Sizing
Over and above that, Money Management allows you to optimize profits and provides good overview of investments that have already been made and potential future investments. Especially when trading, one must always account for potential losses which makes adequate risk management indispensable – loss coverage is a fundamental task in Money Management. Two of the most common mistakes among newcomers in trading with securities are lacking or deficient loss coverage and too large position sizes. Consequently, proper Money Management must include the determination of the right position size.
The meaning of optimal position sizing
Next to loss coverage that can be implemented through many different instruments, e.g. the Stop-Loss-Order, the optimal position size is crucial in trading. Even beginners should understand quickly that the right choice in position size can have severe impact on the amount of potentially lost money. Certainly, it makes a difference whether the investor has to buffer a loss of 100 or only 20 stocks in the depot of a company. There are two basic factors that have influence on determining the right position size; firstly, the investor’s current account balance (available liquidity) and, secondly, the maximum risk that the trader is ready to take in each trade or each day. In this context, experts talk about determination of position size that is an essential part of Money Management.
Maximum risk is self-determined by the investor
Money Management demands important decision making form the investors themselves, as they are assigned with key task of calculating the right position size. As briefly mentioned already, the current account balance is a defined factor that is crucial in determining the proper position size. This is valid for the moment in which the investor would like to place the order. Contrary to the account balance, the maximum risk is a variable factor that is just as important when trying to minimize potential losses by calculating the right position size. Basically, the characters of the investors and their risk attitude have influence on the position size.
When identifying the tolerable risk, investors should ask themselves which level of loss would cause them to react calmly without panicking. Ask yourself what loss you could cope with per trading day without tossing and turning at night. Once you have identified this limit, you have automatically determined the maximum risk you are willing to take each trading day. Hence, you have already identified one of the two crucial factors in determining the optimal position size. An alternative to specifying the maximum risk based on a daily amount of tolerable loss is the method of estimating a percentage. This arrangement needs you to set a certain percentage of loss tolerable per trade and also relies on your current account balance.
Exemplary determination of the optimal position sizing
Now that you have been introduced to the theory and the factors that are important when determining the position size, it makes sense for us to guide you through the determination process of a realistic example. Firstly, you have set the maximum risk you’re willing to take. In this exemplary case, the maximum chance of loss amounts to 300 Euro or 1.5 percent of your account balance that currently holds $20,000. Based on this information you can easily determine the optimal position choice for any trade.
Let us assume that you are interested in a stock with a current stock price of 40 Euro. Of course, you would like to implement loss coverage as part of your Money Management, and immediately when placing the order you include the Stop-Loss-Order that would interfere at a stock price of $39. Based on the facts that you accept a loss of $300 per day and that the trade stop will interfere at a price loss of 1 Euro, you can now estimate your individual position size: In this case you can buy 300 stocks which is also the optimal position size that has a value of $12,000. The Stop-Loss-Order limits the possible overall loss of this position to $300 and at the same time the targeted maximum risk per trade of 1.5 percent of the current account balance, $300, is maintained.