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Trading Lessons: Position Size Matters


Constraints form the basis of a sound investment plan.

Professor Smita,

Thanks for your updates. I find them very helpful. I had a question regarding position size. I am curious as to how you measure it, i.e., as a percentage of your overall account or via another metric. Your thoughts would be welcome.

-Minyan Kabir

Minyan Kabir,

Thanks for your note. You've touched upon a very pertinent aspect of money management that determines a lot of trading outcomes -- yet I've seen very little discussion of it.

Everyone has their individual position size metric, and that's dependent on several factors; for instance, how much of their total assets they have earmarked for trading/active investing, their risk profile and time horizon. Inappropriate sizing of positions can lead to large draw-downs, which trigger inappropriate trading strategies and compound the initial errors.

In reality, most of the trading losses stem from the realm of avoidable trading mistakes. Asking the right question is the first step toward prudent trading. This journey of a thousand miles (into the world of trading) ought to begin with the following 3 questions!

1. How do I adjust my positions within the context of the market?

The position size can't be dependent on the position of stock alone; it has to rely on (at least) the following 2 important variables:

Market trend

The first question one has to answer is what market cycle we're in and adjust their strategy accordingly. In a bear market for instance, cash, as a position, should require a much bigger allocation. The positions have to be sized in the context of the market environment -- this bear market, the latest bounce not withstanding, has been very vicious and I believe that individual risk appetite should be somewhat tempered, leading to smaller-than-normal position sizes.

Volatility of the entire market

Position size in individual securities needs to be adjusted for the volatility of the market at a certain point in time; highly volatile market time calls for more defensive measures in the form of smaller-than-normal position sizes. For instance, here's an excerpt from December 12, 2008's buzz about market volatility:

"Up until the start of 2008, a daily move of 4% in a 50-day period was noteworthy. From 1945 through 2007, the S&P 500 had 49 one-day moves of 4% or more, which is an average of less than one per year. This year we've had 28! For a market as big as the United States to average a 4.02% daily change over a 50-day period is truly astounding."

(Buzz subscribers can refer here to Wacky Volatility.)

2. How do I allocate my account among various holdings?

Various strategies can be effective. I personally allocate a fixed percentage of my account to each security, which translates into a certain fixed dollar amount earmarked for each security (that's a lot easier to handle when it's time to initiate the trade).
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No positions in stocks mentioned.

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