“In a lecture to his students at a 1991 retreat in Hawaii, fellow Market Wizard Ed Seykota said that once you know the expectancy of your system, the most important question a trader can ask is, “How much should I invest?” One of the most frequent questions I’m asked is how to determine the correct position size per trade. Ultimately, this becomes a discussion of how many stocks to hold in a portfolio.”
- Mark Minervini
When it comes to position size, you need to remember that we’re not allocating money. We’re allocating risk. That’s the key to understanding position sizing. Therefore, position sizing, in simpler words, means how many units I can buy of a particular scrip within the defined risk.
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Let me explain it to you with an example.
Let’s say, you start with a trading capital of Rs. 10,00,000/- and you decide to risk 0.3% of your capital per trade, the less experienced you are, the less risk you should take on because you are at or near the bottom of the learning curve and more prone to making mistakes and therefore losses. So first, you must calculate your risk of ruin:
Capital/0.3% = 10,00,000/3000 = 333 trades, which means it will take 333 consecutive losing trades to lose your entire capital. This seems like a zilch probability.
Now let’s say your system generates a buy signal for stock X which is priced at Rs.150/- and your system stop loss for stock X is, let’s say, 6%, which means 150*6% = 9. Hence if your entry rate is Rs. 150, your stop loss for the same would be Rs. 150 less 9 = Rs. 141/-. Now comes position sizing into play, which is basically “How many units of stock X can you buy with a risk of 3000?”
The answer is you can buy 3000/9= 333 units of stock X. Next, what is your capital deployed in stock X? It is 150*333= 50,000. So, to sum it up, you have deployed 5% of your capital (Rs. 50,000/-) with a risk of 0.3% of your capital (3000).
So, by deploying 5% of your capital in each stock, you can buy about twenty stocks in order to deploy the entire capital of Rs. 10,00,000/-. And what will be your risk presuming you get stopped out in all twenty stocks? If you get stopped out is 0.3%*20= 6%. In short, you end up losing just 6% of your capital or Rs. 60,000 if your entire capital of Rs. 10,00,000/- is deployed.
This is presuming all the stocks get stopped out in a worst-case scenario, of which there is a low probability but it can’t be ruled out. On the flip side, you may end up with few winning trades in the twenty stocks that you have bought. In such a case, your risk will be much lower on an overall basis.
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So, should one have a diversified portfolio or a focused one?
If you allocate a lower percentage of risk, you end up with a diversified basket of stocks. The advantage here is that since you are diversified and have a greater number of stocks and if you are “lucky” enough some stock or the other may work well. Maybe the majority will give you subpar results but about 5%-8% of your stocks may turn out to be outlier trades which can give you multiple returns. But on the flip side, because of lower capital deployment the incremental percentage gain on the portfolio may be average.
In contrast, a concentrated portfolio comes with its set of advantages and disadvantages. As mentioned, if the 5%-8% outlier trades do well it will have a significant positive impact on your overall portfolio returns but on the flip side if the majority don’t do well it will have a negative impact on your portfolio. To each its own, as said earlier, whether to go with diversified or focused bets has a lot to do with your “personality” only you know what will work the best for you.
Once you have understood position sizing, the next important component is money management.
“Money management is the secret behind survival and big profits. The essence of proper money management is very simple—when you lose money from trading, you should reduce your trading exposure or position size, and when you make money from trading, you should increase your trading exposure or position size.”
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Here are two ways of money management:
Martingale: Martingale money management looks to trade more contracts when you lose and fewer when you win. It appeals to the gambler’s instinct to ‘‘double up’’ after a loss. Martingale money management follows the theory that there is a higher probability a winning trade will follow a losing trade, and therefore one should take advantage of it by trading more contracts following a loss.
This strategy is very dangerous as you keep doubling your bet size on the downside in order to recover the lost amount. Since markets are all about probability, it’s very uncertain to predict when the next winning trade will come, thus increasing your risk of ruin.
Anti-Martingale: Anti-Martingale money management will help you to survive because it directs you to trade less when you lose and more when you win. This thereby lowers your risk of ruin probability drastically.
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Kirit Manral is a professional trader, and has been running a mentorship program in trading since 2019, with mentees from around the globe. He can be found on Twitter at @KiritManral