One very important factor in trading is deciding how much size to use on each trade. There are a variety of methods for choosing position size. It could be a flat number of shares (such as 1000), a flat $ amount per trade, or a percentage of your total account size. There are also more advanced methods such as the Kelly Criterion.
However, there are problems with these various methods. If you use a flat number of shares, your position size will dramatically change based on the price of a stock. If you use a flat $ amount per trade, your position size won’t grow as your account size grows. Your percentage gain shrinks with each winning trade. Also, if you go on a losing streak, you’ve got a finite number of trades you can lose on before you lose all your money. For example, if you’ve got $50,000 and you risk $1000 per trade, your money is gone if you get 50 losers in a row (unlikely but you get my point). The percentage loss of your account also goes up with each losing trade…risking $1000 after you’re down to $40K is a bigger percentage riks than risking $1000 when you’ve got $50K.
The Kelly Criterion is popular with some traders, but it requires knowledge of your win probability and win/loss ratio. Unless you’re a systems trader with a well-defined win probability, this can be difficult. Also, use of the Kelly Criterion can result in wild swings in your account, which can be psychologically difficult for some traders. The Kelly Criterion doesn’t leave you a lot of room for error. If you make a bunch of mistakes in a row, you’ll take a big hit to your account. Finally, if there are limits to the scalability with your strategies (like when trading smallcaps), you may run into position size limits fairly quickly when using the Kelly Criterion.
I’m here to make the case that the best method for most traders will be Van Tharp’s position sizing method of using the location of your stop loss in combination with a small percentage-based risk amount. For example, if you have an account of $50,000 and you want to risk 1% per trade, that means you’ll risk losing $500 if a trade hits your stop loss. So if you’ve gone long at $10 and your stop loss is at $9, then your position size will be 500 shares (you’ll lose $500 if the stock hits $9). This is the method I use and is the one my free position size calculator is based on. Let’s talk about the advantages of using this method.
Doesn’t Require Knowledge of Your Win Probability.
Unlike the Kelly Criterion, using a percentage-based risk amount based on your stop loss does not require knowledge of your win probability. Whether your win percentage if 25%, 50%, 75%, or something else is irrelevant…position sizing will always be the same.
Easy to Control The Magnitude of Drawdowns
If you risk 1% of your capital per trade using Van Tharp’s methods, then you know ahead of time how much of a dent a losing streak can cause. For example, you’ll know that 10 losing trades in a row will be approximately 10% of your capital. In fact, it will be a bit less than that (ignoring fees and slippage of course), since your capital shrinks with each loss. In other words, after a 1% loss, you’ve got 99% of your capital remaining. After another 1% loss, you’ve got 99% of that 99%. After 10 losing trades, you’ll have approximately 90.4% of your original capital. Of course, that’s nitpicking, and you can just go with the quick and dirty method of a 10% loss.
With this knowledge, you can determine what type of drawdown you can tolerate, and how many losing trades you would need in a row to get to that drawdown. Personally I risk 2% of my capital per trade. The most losers in a row I’ve had is 8 losers in a row, which is an approximately 16% drawdown, which is a decent size drawdown. Thus, 2% is my max I am willing to do…I won’t do more because a losing streak will put too much of a dent into my capital. For example, if I risked 3% of my capital, then I’d lose nearly a quarter of my capital if I had 8 losers in a row. And you should ALWAYS assume that you could go on a losing streak, ESPECIALLY if your trading system has a lower win percentage rate. In fact, the lower your win rate, the longer your potential losing streaks can be.
Position Sizes Scale Up & Down With Account Size, and You’ll Take Advantage of Compounding Returns
You’ll often hear about traders who “size in” when they’ve got good conviction on a trade and/or when they’re trading well. I’m not a fan of this practice because no matter how good your conviction is, you can still lose. And if you keep sizing in while you’re trading well, you could eventually lose and take a chunk out of what you worked so hard to build. However, Van Tharp style position sizing takes care of this problem. If you’re trading well, your position sizes will automatically grow as your account size grows. If you’re using 1% based risk, your position sizes will double when your account size is $100K vs. $50K (you’ll be risking $1K per trade rather than $500). You’ll take advantage of compounding returns.
It’s often said that you should scale down if you’re not trading well. Again, this method takes care of that automatically. If you go on a losing streak and your capital shrinks, your position sizes will automatically shrink with it. So if you’ve got $100K but you’ve taken a bunch of losers in a row and now you’re at $90K, your position sizes will decrease by 10% accordingly.
If You’re Trading Poorly, You’ll Be Buying Yourself Time & Reducing Risk of Ruin
If you risk 1% per trade, you could think that you’d have to have 100 losing trades in a row to lose all your money. However, it’s better than that. Because each trade is a percentage risk, you’ll be constantly “resetting” yourself for 100 losers in a row with each trading loss. That’s because your position size will shrink along with your account size. For example, to truly lose 50% of your capital, you’d have to have approximately 70 losing trades in a row (and not 50) (0.99 to the 70th power). If you had 100 losing trades in a row, you’d still have about 37% of your original capital left (0.99 to the 100th power). Thus, using this form of position sizing buys you time to figure things out if you’re on a losing streak.
Psychologically Easier, Especially When Scaling Up
If you risk 1% of your capital per trade, then you know you’re only risking 1 cent for every dollar. It helps put your risk in perspective. It also makes things psychologically easier as your account size grows. If your account size grows to $500K, it’s easier to think that you’re just risking 1 cent on the dollar for every trade rather than risking $5000 per trade.
Give Van Tharp Percentage Based Position Sizing A Try
It’s a great method for a lot of traders with a lot of advantages. It reduces risk of ruin while simultaneously allowing you to compound your account. Personally I wouldn’t risk more than 1-2% of your capital per trade (I do 2%). Any more than that, and losing streaks can start to put big dents in your capital. If you want to be able to quickly estimate your position sizes while trading, try out my free position size calculator.