Position sizing refers to the shares that investors or traders invest in particular securities. When determining the appropriate position sizing, the investor’s account size and risk tolerance are the two critical parameters taken into account.
In simple terms, position sizing refers to (the size of) the market position of a specific investment portfolio or investor trade. Investors use this tool to determine how many security units to buy to manage risk and maximise profit.
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Position size refers to the number of shares, or equivalent money, an investor or trader invests in a particular security.
Investors should consider risk tolerance and account size when determining an appropriate position size. Even if the position size is reasonable, the investor’s loss may exceed the set risk limit if the action is below the stop-loss order. To understand what it means and how it is used, let’s take a closer look at some details of position sizing.
Position sizing and risk management
To add to the definition mentioned above, position size is the number of shares you have bought in the market that establish a balance between your psychological comfort and the risks taken on your account.
An ideal position offers an outstanding balance between your psychological and risk profile. It is essential to understand and analyse the moves that occur in the stock market.
Equal value position sizing
In equal value position sizing, you allocate the same amount of money to all stocks. See what this means in the following example.
For example, your account size (the total amount you want to invest) is Rs. 1,00,000. You decide only to trade 20 shares in one year. In this case, you have fixed the amount to be invested in market participation by buying or selling a stock. Thus, by dividing Rs. 1,00,000 with 20, you will get the maximum allocation under equal value position sizing for each trade as Rs. 5000.
That is why it is called the equal value position-sizing strategy. This means that in each of your market trades, only Rs. 5000 will be involved. Thus your position will be fixed at Rs. 5000 per trade.
Equal value sizing is more suitable for passive traders and investors and is easy to implement. If you are not a full-time trader and are a market participant on the side, this can be a suitable sizing method for you.
Equal risk position sizing
Equal risk position sizing involves setting an initial stop loss and then deciding how much you can risk. Equal risk position sizing is determined by the difference between where the trade enters and the set stop-loss order. The stop-loss closes the trade if it loses a certain amount of money (by reaching a predetermined price set by you). Therefore, the risk of each transaction remains within the account risk limits.
When initiating a trade, consider the entry point and the stop-loss point seriously. You should set stop loss as close to your entry point as possible but not close enough to stop trading before the expected price change.
Once you know how far you are from your entry point, you can calculate the ideal investment size for the trade. This is done as a percentage, and experts recommend not to exceed 0.5-2% of your account total.
Assume that you take a 2% risk on the Rs. 1,00,00 account size. This will give Rs. 2000 value for risk (2% of 1,00,000).
This means that the risk amount per trade is set at Rs. 2000
Equal risk position sizing = risk per trade / (Difference of Entry and Stop Loss)
=> 2000/ (100-80) => 2000/20 = 100, (assuming that you bought one share at 100 and set stop loss at 80).
An equal risk position sizing of 100 will mean that 100 is the maximum position size (number of shares) you can take on the trade at your risk level of 2%.
Good position sizing is the key to successful trading. Remember that if you take too little risk, your account will not grow. But if you take too much risk, you can quickly empty your account. Use a balanced approach based on your skills and insights from trusted sources.
