Published on: September 30, 2024
“My system’s strike rate is 81%, but I am still not making big profits. Does this haunt you, too?”
If you have ever experienced this paradox, you are not alone. You may have a strong system with an impressive strike rate and even a solid risk-reward ratio. Yet, despite all this, something crucial might still be missing, holding you back from consistent and significant returns. The missing piece is often Position Sizing.
Position sizing is the unsung hero that can change the game for you.
Let me walk you through this critical concept, which is often overlooked yet one of the most important factors differentiating the profitable 1% of traders from the rest. Position Sizing is the art of determining how much capital to allocate to a particular trade or investment, and its correct application can transform your trading performance from good to great.
What is Position Sizing?
Position Sizing determines the number of units or shares you buy or sell in a given trade or investment. It answers the essential question – How much should you bet on this opportunity?
Position Sizing is the glue that holds together a sound trading system. It ensures you don’t over-leverage or under-commit in any single trade, helping you stay in the game long enough to let your edge play out over a series of trades.
Position Sizing Feature
Let us explore the different types of position sizing methods that can bring this concept to life.
Types of Position Sizing
There are various methods to determine position sizes, and choosing the right one for your strategy is key to success. Here are some of the most common and effective types of position sizing methods:
1. Risk-Based Position Sizing
2. Volatility-Based (ATR) Position Sizing
3. Exposure-Based Position Sizing
4. Kelly Percentage Position Sizing
Each has its own strengths and fits different trading styles, but when combined with your risk-reward strategy, they can optimise your trading performance.
1. Risk-Based Position Sizing
Risk-Based Position Sizing involves determining how much money you are willing to lose on a single trade. This method is crucial for protecting your capital because it ensures you never risk too much on any one trade.
Let’s break it down:
Step 1: Define your risk per trade as a percentage of your total capital. For example, if you have Rs.100,000 and are willing to risk 2% per trade, the most you will lose on a trade is Rs.2,000.
Step 2: Calculate the difference between your entry and stop-loss prices, representing the risk per unit.
Step 3: Divide your maximum risk (Step 1) by your risk per unit (Step 2) to determine the number of units to trade.
Example:
Assume you are buying a stock priced at Rs.50, and your stop-loss is at Rs.45, so you risk Rs.5 per share. If your risk tolerance is 2% of your Rs.100,000 capital, you risk Rs.2,000 per trade.
So, the number of shares you should buy is:
This approach keeps your risk consistent across all trades, helping you stay in control and avoid catastrophic losses.
2. Volatility-Based (ATR) Position Sizing
Volatility-based position sizing adjusts your position size based on the asset’s volatility. It uses the Average True Range (ATR), a popular technical indicator, to measure volatility and sets the position size accordingly.
A more volatile asset will have a smaller position size to account for the wider price swings, while a less volatile asset will allow for a larger position size.
Example:
Let’s assume the ATR for a stock is Rs.2, meaning the stock’s average movement is Rs.2 per day. You use a multiplier of 3 to set your stop-loss at 3x the ATR (3 X 2 = Rs.6).
If you risk Rs.2,000 on this trade, you can calculate the position size like this:
Adjusting the position size based on volatility allows you to align your trades with the market’s natural movement, preventing premature stops during normal fluctuations.
3. Exposure-Based Position Sizing
Exposure-based position sizing helps control your exposure to any single asset or sector. It limits how much of your portfolio is allocated to any one trade, ensuring diversification and reducing the impact of a single loss.
Example:
If you decide that no single trade should represent more than 10% of your Rs.100,000 portfolio, your maximum position size would be Rs.10,000. If the stock you want to buy is trading at Rs.50 per share, you can purchase:
This method controls your exposure and prevents over-commitment to any one trade or sector, which could lead to heavy losses in case of adverse market moves.
4. Kelly Percentage Position Sizing
The Kelly Percentage method is a mathematical formula that helps you calculate the optimal position size based on your past trading performance, precisely your win rate and the risk-reward ratio. It aims to maximise your capital’s growth rate over time while minimising risk.
The Kelly formula is: Kelly % = W – (1 – W)/R
Where:
W is the win probability (strike rate)
R is the risk-reward ratio
Example:
Let’s assume your system has a win rate of 60% and your average risk-reward ratio is 2:1. Using the Kelly formula:
Kelly % = 0.60 – (1 – 0.60)/2 = 0.60 – 0.20 = 0.40 or 40%
This means you should allocate 40% of your capital to the trade. However, most traders, depending on their trading style, use half or even one-third of the Kelly percentage to reduce volatility in their returns.
Position Sizing in Action: Definedge Zone Web-Based Trading
At Definedge Securities, we are proud to be the first in the industry to offer Position Sizing (P) execution with an integrated button next to the Buy (B) and Sell (S) on our Zone Web trading platform. This tool allows you to seamlessly incorporate position sizing into your trades using the four methods discussed above. It ensures precise execution and takes the guesswork out of how much to invest or risk on each trade.
To summarize, imagine combining your powerful trading system with the right position sizing method. Suddenly, your system isn’t just about strike rates or risk-reward ratios; it becomes a complete strategy designed to maximise returns while minimising risk. Irrespective of your trading style or asset classes like trading stocks, commodities, or currencies, always remember to ask yourself, “How much should I risk on this trade?”
The answer could make all the difference in your long-term trading success.