One of the most important aspects of trading is position sizing. How much will I put into this trade? This number can be arrived at a number of ways with different purposes in mind. You can set it up in such a way to:
- Minimize Drawdown
- Maximize Return
- Target Specific Risk
- Maximize Risk-Adjusted Return
Market Strength My first step is a daily market analysis from which I assign a number from 1% to 3%. 2% is a normal market and the rest is quantitatively ranked and weighted from different models. The purpose of this step is from the wisdom best summarized from Mark Minervini, "When the market starts to turn, I just dip my toes in and don't add or increase position sizing until the my positions show a profit." The Market Strength section drives the size of the overall position once it is calculated from other factors. Strat Factor Strategy factor is another position adjuster based off of the risk of the strategy I am buying based off. Some strategies such as BS are very risky in nature, and while the trade has potential for 100%+ gains, it can be volatile in the mean time. This entry is also late and causes some gains to be minimized. For this reason position sizes are lower for the BS trade. This column lowers or raises position sizing based on the specific factor of the strategy itself. R I like to track what "R" my current position is in. From my past trading I know that I need a 1:3 Risk Reward ratio to remain profitable. From here I can watch my positions easily. When This reaches 2 it lights blue, informing me to move my stop to break even, and when it reaches green it tells me that it has reached the minimum objective (3) and allows me to further analyze the position to leave it, take some profits, or possible even just sell the whole thing. ATR Because my main concern is lowering volatility in my equity curve, I use ATR to initially set my position sizing. All position sizing are based of off ATR * ATR Multiple. The ATR is my proxy for the volatility of the position. ATR Multiple and Distance from 10 Week SMA Stocks that are far above the 50 day SMA or 10 Week SMA are inherently riskier in nature. Stocks can only stretch so far from this "heavily watched" moving average. In buying breakouts and growth stocks, some stocks tend to be very high above the 50 day, and this is risk I would like to be adjusted for in my position sizing algorithm. I got this simple idea to adjust for risk in this way from Derek Hernquist. The more distance there is above the 10 Week, the higher the multiple and therefore lower the position sizing used in the eventual outcome. Portfolio Value The last thing that is crucial for position sizing is the size of your portfolio. The original Market Strength rating system is based of off the fact that long-term success tends to come from risking 0.5% to 3% of your portfolio per trade. After being adjusted for various factors, you can see that eventually portfolio risk is smaller than the market strength rating, however, the philosophy is kept in tact. By making it a strict rule that I can NEVER buy more shares than this simple algorithm computes, I will lower risk and keep my portfolio in check, no matter the mania that may ensue in the market. Checkpoints Other things I track are my objectives for certain trading multiples of R as well as the price I must buy below to put the trade on. Knowing my average return and expectancy, I know what my individual position risk must be below in order to initiate a trade, and therefore I can build that as a check in the this size. For more information on expectancy and backing into certain multiples and prices, see this post. Overall the premise is simple, but the effect is powerful. Give some thought to your goals, and what position sizing adjustments may help you reach those goals.