When buying assets, quality matters. Buying the right projects and companies can take you a long way. But quantity matters too. Setting an appropriate position size can also play a huge role in securing your financial health. And this article focuses on just that—the “how much” part of investing.
What is position sizing?
In the term “position sizing,” “size” is the number of units of an asset you’re buying. So the term refers to selecting how much of the asset you buy due to the “position” you’re taking in the market.
The position size you choose depends on your risk tolerance and how much of the asset you consider safe or appropriate to buy. Too much of one asset means you are overexposed to the risks involved. And too little means that you lose out on potential gains.
The point is to have a balanced and well-diversified portfolio. And various position sizing techniques could help you build such a portfolio. In that sense, diversification is the end, and position sizing is how you get there.
Reducing risk with an optimal position size
Traders use position sizing to manage trading risks. Adjusting the size of a trade to the capital that you’re willing to lose lets you spread the remaining money across trades. That way, you get to take a shot at maximizing profitability. In other words, optimal position sizing helps reduce trading risks and ensures that your trades factor in your risk appetite.
To determine the position size that is optimal for you, you could try the following things.
1. Identify the appropriate stop level
The stop level is the level at which your stop-loss order is executed (that is, sold if the security falls to that price). Identifying the stop level appropriate for you helps reduce risk by limiting potential losses on a single trade.
A stop-loss percentage of 2%, for instance, would limit the total risk to 2% of your invested amount. That is a lot better than risking 100% of your investment.
Stop-loss is one of the most common position-sizing techniques, but there are others options too.
2. Look for alternative position-sizing techniques
Some of the other ways in which you can determine the right position size for your portfolio are:
Adjust your size with volatility: Crypto is considered to be more volatile than stocks. So, if you were to adjust the position sizes of assets in your portfolio through volatility, taking on a smaller trade risk on crypto compared to a relatively high one on stocks may be wise.
Diversify: Instead of increasing your position size on particular assets, try to diversify as much as possible. So even if some of your trades go south, others can compensate.
3. Establish a daily stop level
A daily stop level is the amount of loss an individual can tolerate on a daily basis. This is typically a percentage of the capital available. The principle remains the same: Limit your potential losses to a few percentage points every day, so you don’t risk everything every day.
Position sizing example
To understand position sizing better, let’s get into the shoes of Trader X with $10,000 of capital. A combination of X’s account and trade risks determines their appropriate position size.
Account risk
It is important that investors determine their account risk. Typically, investors do not risk more than 2% of the total account size, which in this case, is $10,000. So X cannot risk more than $200 on one trade. Active traders and fund managers risk even less. By limiting one’s position size in this way, one may limit a lot of losses too.
Trade risk
Another way to limit loss is using stop-losses and taking calculated trade risks. If X decides to buy a single unit of crypto coin A for $100 and sets a stop-loss at $80, they’re limiting their trade risk to $20. This risk increases if X decides to take a lower stop-loss or buy more of the same asset.
Proper position size
Combining the two above, we know that $200 can be risked on one trade, and the risked amount per coin of cryptocurrency A is $20. Dividing account risk ($200) by trade risk ($20), X can, thus, afford to buy 10 coins of that cryptocurrency in one trade.
Position sizing and gap risk
In addition to everything we’ve discussed so far, there’s one more thing you need to keep in mind—gap risk. This is when the price of an asset falls drastically from one trade to the next. Gaps in trading usually occur due to negative news about the company or project. While position sizing can address or eliminate other risks, gap risks may lead to unforeseen losses.
So whenever one expects increased volatility, it may be wise to halve the position size.
Conclusion
In conclusion, position sizing is a crucial aspect of trading. It can help to manage risk by:
- Using a fixed percentage of the account for each trade
- Setting stop-loss levels
- Using volatility to determine position size; and
- Diversifying the portfolio
It is also important to constantly monitor the market and your positions to learn from your mistakes and achieve your financial objectives using proper risk management.
FAQs
What is position sizing?
Position sizing is a technique in trading to help manage risk. It involves adjusting the size of a trade to the account size and volatility of the security being traded. Selecting appropriate position sizes works hand-in-hand with risk management. It aims to bring greater diversification to your portfolio.
How do you determine your position size?
There is no ready rule of thumb traders can use. However, most investors use a combination of account and trade risks to determine the position size of each asset they hold.
How can you reduce risk with position size?
Position sizing reduces risk by checking one’s exposure to all stocks or cryptocurrencies. By using stop-losses, assessing account risks, and limiting trade risks, you can establish the maximum amount of money you could possibly lose.
When should I increase my position size?
Active traders with large amounts of capital often reduce position sizes to deal with volatility. We recommend you only increase your position size if you’re confident about a project or slowly bringing down your average buy price.
What is the ideal position size?
The ideal position size for a trade is determined by a calculated percentage of your total trading capital, usually limited by your trade risk, typically around 1%.
What is the position size rule?
The position size rule suggests risking a small percentage of your total trading capital per trade, typically between 1-3%, to manage risk and maximize returns.
