Position sizing and risk

Page 5 gave every trade a risk measured in dollars per share: the distance from entry to stop. Position sizing is the step that turns that into a number of shares.

The principle is that the stop decides the size, not a feeling about how good the trade looks.

Sizing from the stop

The arithmetic has three parts:

1. The amount at risk on the trade, in dollars.
2. The risk per share: entry minus stop for a buy, stop minus entry for a sell.
3. The first divided by the second, which is the number of shares.

An example with made-up numbers. Suppose the amount at risk is $500, and a signal has an entry at $50.00 and a stop at $48.00. The risk per share is $2.00. Dividing $500 by $2.00 gives 250 shares.

Now take a second signal, with the stop only $1.00 below the entry. The same $500 gives 500 shares. A third, with a $4.00 stop, gives 125 shares. The position changes size so that the dollars at risk stay the same: in every case, being stopped out costs $500.

That's the point of sizing from the stop. A trade with a wide stop gets a smaller position, and one with a tight stop gets a larger one, and the account is exposed to the same risk either way.

A fixed share of the account

How is the amount to risk chosen? A common convention is a small, fixed percentage of the account on each trade. The examples here use 1%, purely as an example. With a $50,000 account, 1% is the $500 above.

Using a percentage has a useful effect. When the account grows, the dollar risk grows with it. When the account shrinks, the dollar risk shrinks too, so a poor stretch slows itself down.

The right percentage depends on the individual: on the size of the account, on how much the account can lose without changing a person's circumstances, and on how that person copes with a drawdown. The course can show the arithmetic. It can't choose the number.

Two practical points:

• The position's cost can be large. In the example, 250 shares at $50.00 is $12,500, a quarter of the account, to risk only 1% of it. The money tied up is a different figure from the money at risk.
• A stop isn't a guarantee. If a stock opens well beyond its stop, say after overnight news, the loss on that trade can be more than planned. Sizing sets the planned risk. It can't remove the gap.

Why a run of losses must be survivable

The case for small, fixed risk is about sequences, not single trades. Any method will have runs of trades that don't work, and page 7 looks at how long they can be.

The arithmetic is gentle if the risk per trade is small. Ten stops in a row at 1% each leave an account about 9.6% lower. That's uncomfortable, but the method is still running and the next signal can be taken at nearly full size.

Risk 10% per trade and the same ten stops leave the account about 65% lower. The method may be sound, but the account can no longer make use of it.

Recovering from a loss also takes more than the loss itself. A 10% fall needs an 11% gain to get back, and a 50% fall needs 100%. The deeper the hole, the harder the climb, which is another reason to keep each trade's risk small.

Where this leads

Sizing and stops keep each trade's cost known. The next page asks what a series of trades looks like in practice.

Next: What to expect.