Right Sizing Your Trading

by: The Mad Hedge Fund Trader

Editor's note: Article originally published February 26, 2016.

I can't tell you how many times I have been woken up in the middle of the night by an investor who was sleepless over a position that was going the wrong way. Gold was down $50, the euro was spiking two cents, or the stock market was enduring one of its periodic heart attacks. Of course, my answer is always the same. Cut your position in half. If your position is so large that it won't let you sleep at night on the bad days, then you have bitten off more than you can chew.

If you still can't sleep, then cut it in half again. Which brings me to an endlessly recurring question I get when making my rounds calling readers. What is the right size for a single position? How much money should they be pouring into my Trade Alerts? Spoiler alert! The answer is different for everyone.

For example, I will not hesitate to pour my entire net worth into a single option position. The only thing that holds me back is the exchange contract limits. But that's just me. I have been trading this market for nearly half a century. I have probably done more research than you ever will (I basically do nothing but research all day, even when I'm backpacking, by audio book).

And I have been taking risks for my entire life, the financial and the other kind, quite successfully so, I might say. So my taking a risk is not the same as your taking a risk. Taking risks is like drinking a fine Kentucky sipping Bourbon. The more you drink, the more you have to imbibe to get a good buzz. Eventually, you have to quit and start the cycle all over again. Otherwise, you become an alcoholic.

So you can understand why it is best to start out small when taking on your first positions. Imagine if the first time you went out to drink with your college dorm roommates and you finished off an entire bottle of Ripple or Thunderbird? The results would be disastrous and nauseous, as they were for me.

So I'll take you through the drill that I always used to run beginning traders at Morgan Stanley's institutional equity trading desk. You may be new to investing, new to trading, and find all of this money stuff scary. Or you may be wary, entrusting your hard earned money to advice from a newsletter you found on the Internet!

What if my wife finds out I'm doing this with our money? Yikes! That is totally understandable, given that 99% of the newsletters out there are all fake, written by fresh faced kids just out of college with degrees in Creative Writing, but without a scintilla of experience in the financial markets. And I know most of the 1% who are real.

I constantly hear of new subscribers who are now on their tenth $4,000 a year subscription, and this is the first one they have actually made money with. So it is totally understandable that you proceed with caution. I always tell new readers to start out paper trading. Virtually all online brokers now have these wonderful paper trading facilities where you can practice the art with pretend money.

Don't know how to use it? They also offer endless hours of free tutorials on how to use their platform. These are great. After all, they want to get you into the market, trading, and paying commission as soon as possible.

You can put up any conceivable strategy and they will elegantly chart out the potential profit and loss. Whenever you hit the wrong button and your money all goes "poof" and disappears, you just hit the reset button and start all over again.

No harm, no foul. After you have run up a string of two or three consecutive winners, it's now time to try the real thing. But start with only one single options contract or a few shares of stock or an ETF. If you completely blow up, you will only be out a few hundred dollars.

Again, it's not the end of the world. Let's say you hit a few singles with the onesies. It's now time to ramp up. Trade 2, 3, 4, 5, 10, 50, or 100 contracts. Pretty soon, you'll be one of the BSDs of the marketplace. Then, you'll notice that your broker starts following your trades since you always seem to be right. That is the story of my life. This doesn't mean that you will enjoy trading nirvana for the rest of your life. You could hit a bad patch, get stopped out of several positions in a row and lose money. Or you could get bitten by a black swan (it hurts).

Those of you who have been following me for eight years have seen this happen to me several times and now know what to expect. I shrink the size, reduce the frequency, and stay small until my mojo comes back. And my mojo always comes back.

You can shrink back to trading one contract or quit trading altogether. Use the free time to analyze your mistakes, rethink your assumptions, and figure out where you went wrong. Was I complacent? Was I greedy? Did hubris strike again? Having a 100% cash position can suddenly lift the fog of war and be a refreshingly clarifying experience. We all get complacent and greedy. To err is human. Then, reenter the fray once you feel comfortable again. Start out with a soft pitch.

Over time, this will become second nature. You will know automatically when to increase and decrease your size. And you won't have to wake me in the middle of the night.

Good luck and good trading.

Disclosure: No positions