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Becoming a Better Trader: Position Sizing


No single position should occupy more than 5% of your total capital.


Yesterday I wrote the first piece in a series regarding adopting rules to govern your trading. The point was to relay my firm belief that in order to achieve continued success, one must adopt and adhere to a set of rules or guidelines when trading stocks.

Furthermore, I am a firm believer that each individual needs to personalize their rules in order to correlate with their personality. Some may have a smaller capital base and need to limit losses with very tight stop levels while others may desire to give their stocks a longer leash but take smaller position sizes. Every trader is different and therefore no trader should have all the same rules as the next. Over the next several days I will share with you my rules with a goal of sparking your creative juices and possibly putting you on the path to creating and adopting your own.

Rule #1: Position Sizing
No single position will occupy more than 5% of my total capital.

Position sizing absolutely needs to be addressed but many may be surprised to see it as my #1 and I am sure many would debate the level of importance of this rule.

For years I never adhered to a set rule on position sizing: rather, I simply dealt with round numbers. When I first started trading, I would trade in 100 share lots of each stock.

Obviously as the prices were sometimes much different, these positions would ultimately take up much different weight in my portfolio. As time went on, I would adjust this slightly but my brain always thought in 100 share lots and nothing more. As my capital account grew I was forced to alter my sizing and increase my share count. Keeping it simple I would simply adjust my buying. Rather than buy 100 share lots, I bought 200. Eventually, I stepped it up to 300, 400 and so on. Over time my comfort level would grow and eventually in order to keep performing the way I desired I would have to increase my share count.

Everything was going just fine but when I went through a draw, I started noticing that they became more and more severe over time. It wasn't that the correction was worse or that the stocks had consolidated more than the previous time, it was that my account was dropping more money. I of course chalked this up to the simple fact that I was managing more money, however that didn't quite hold mustard as I reviewed the percentage of the hit which was also growing on each draw. I started to dig a bit and find out why this was happening. The biggest challenge wasn't such that I was experiencing a bigger draw, it was that repairing the damage was taking longer and longer, which was draining the emotional capital quite a bit.

Read Prof. Tatro's introduction to his trading rules, Becoming a Better Trader: Developing Your Personal Rules.

Finally, as I was reviewing my position sheet, it hit me like a ton of bricks. It seems incredibly simple, but for me it was quite an epiphany.

My problem was not in the stocks I was trading, the correction that was taking place or the way in which I handled the draw: it was my overall exposure to individual stocks. As I looked through my position sheet I realized that I sometimes had eight, nine or even 10% of my money in one stock. When that stock corrected 10% in a normal and healthy manner, it was whacking my total P&L by a healthy 1% each time. My big problem was that I had been increasing my position sizing in round numbers, sometimes doubling or tripling the share count, when my capital base had been growing only 30, 40 or 50%. Furthermore, when you add in the fact that often higher-price stocks would creep into the portfolio, this was zapping my capital quickly and increasing my exposure to volatility at a rapid pace.

Say, for example, someone is used to buying 100 share lots for a $100,000 account. Well, buying 100 shares of General Electric (GE) at $40.00 will be approximately a 4% position. If, however, they decide to pick up 100 shares of Freeport Mcmoran (FCX) at $97 this will occupy approximately 9.7% of the portfolio. If they each move 10%, the General Electric stock will alter the portfolio by approximately .04% while the Freeport Mcmoran will alter the portfolio by slightly under 1%.

Most people I know think in round share count rather than dollars exposed. While it is simple and easy, it hinders them from striking a balance between all stocks both in the good and the bad. Most brokers these days do not charge a different fee for odd lot trades (something different than a round 100 share count) so rather than thinking in round lots, challenge yourself to determine the maximum exposure you desire to have for each position and do a quick calculation before you buy based on the price of the stock in order to find your desired share count.

This will give each position equal weight and keep your volatility in check both during good and bad times.

As an ancillary benefit, establishing a set position size does limit you theoretically to the number of stocks you hold. Another major problem I see traders struggle with is slowly developing their own mutual fund within their portfolio, holding token positions of numerous stocks. So often an active trader becomes stretched too thin attempting to keep up with each and every position.

I have found that by setting my exact position size, which ultimately determines how many stocks I can hold at any given time, it forces me to make a sale before I make a new buy. If I find something new that I desire to own, but I can't decide which stock I desire to cut, should I be fully invested, the new stock is not bought. This keeps my holding count to a manageable number while keeping me disciplined when buying new names.

It is a simple rule, but for me the most important. I find that when I deviate from this rule, trouble is sure to follow. Not only has it helped to steady my returns, but it makes each draw manageable as well.

What's your maximum position size?
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