Position sizing is a very important part of a good trading strategy. This article is designed to briefly cover how three of the most popular position sizing methods for trading: Fixed Percentage/Dollar, Fixed Fractional, Volatility Adjusted.
Fixed Percentage/Dollar
In this method either a specific fixed dollar or percentage of total portfolio equity is allocated to any position. For example if we had $100,000 to invest at 10% per position we would allocate $10,000 to 10 positions, alternatively in fixed dollar terms if we have $100,000 portfolio equity and wish to invest $5,000 per position, we would invest in 20 positions.
The amount allocated to each position is up to the risk profile of each individual investor, but as a rule of thumb the higher the exposure of an individual security the higher the risk. For example a portfolio of 15 – 20 securities is generally more diversified than a portfolio of 5 – 10.
Generally the preferred method for passive investing where no stop loss is used, such as longer-term blue chip portfolios, is an easy and efficient way to allocate capital. By allocating based on a fixed percentage the exposure of the positions always remains constant despite changes in the value of the portfolio equity. For example $100,000 at 10% per position is equal to $10,000, however if the portfolio value increases to $150,000 then each position is worth $15,000 (10%).
If we allocate a fixed dollar amount to each position, as the overall portfolio size increases (decreases) each individual position in terms of a percentage of the portfolio equity will decrease (increase). For example, beginning with $100,000 investing in a maximum of 10 positions at $10,000 each (10%), should the value of the portfolio increase to $150,000 the position sizes as a percentage of the portfolio decrease to 6.67%. The effect of this is to lower the annual return and draw downs over time as we invest a smaller percentage of the overall portfolio in each position over time.
Fixed Fractional
Predominately used by short-term traders, a key example of this is the “2%” rule made famous by the group known as the Turtle Traders. The idea is that generally no more than 2% is risked per trade, although depending on the risk profile of the individual this can be adjusted for some traders, for example prefer 1% risk per trade.
By allocating such a small percentage of capital per trade we greatly reduce the “risk of ruin” or losing all our capital by extending the number of trades required to do so. For example with a $100,000 portfolio risking 1% per trade, if you have 50 losing trades in a row your remaining capital will be $60,500. This method of position sizing reduces the dollar amount risked per trade as the account size decreases and increases the dollar amount risked per trade as the portfolio equity grows.
This method of position sizing employs the use of a known stop loss level which is used to limit the potential losses on a given trade. Knowing the entry price and tailored stop loss on a position allows the trader to make use of leverage to gain larger exposure to a position and make more efficient use of their capital.
For example, a trader has a portfolio of $100,000 and wishes to risk no more than 2% ($2,000) per trade places an order to go long CBA at $80.00 with a stop loss at $78.00. The distance between the entry price ($80.00) and the stop loss ($78.00) becomes the amount of risk per share, to find the volume we simply divide the amount of risk ($2,000) by the risk per share ($2) meaning the volume is 1,000 shares.
Volatility Adjusted
A more advanced method than the fixed percentage or dollar method mentioned above, volatility adjusted or risk parity as it is sometimes referred, allocates capital on a risk weighted basis. This aims to reduce volatility in the returns of the portfolio by allocating less capital to more volatile stocks and allocating more capital to less volatile stocks.
To calculate this we firstly need an arbitrary risk factor, this depends on the individual investor risk profile, for example we may wish to have no one stock likely to increase or decrease the value of our portfolio by more than 0.1% per day or 0.001. That is to say on a $100,000 portfolio no one stock should increase or decrease the overall value of our portfolio by more than $100.
One way to calculate this volatility is through the average true range (ATR) which measures the amount we can reasonably expect a security to move on any given day based off a prior look-back period. To calculate the number of shares to purchase of each security we simply take (equity * risk factor) /ATR, using the example above and assuming an ATR of $0.50, ($100,000 * 0.001) / $0.50 = 200 shares.
Using this method there is generally not a fixed number of equities in the portfolio as is the case with our fixed percentage example above. If we are using a system where we rank the individual securities from a universe of stocks according to a particular measurement i.e. momentum score, we would continue purchasing stocks using the above calculation until we run out of money. For example if the higher ranking stocks happen to be more volatile we will end up holding a greater number in the portfolio where as if the stocks happen to be less volatile we will end up holding a smaller number in the portfolio.
If you are interested in identifying trends using technical indicators you may find part three of our technical webinar series useful, simply click here.
