When trading in the stock market, position sizing is where all the tools of money management come together. It’s possibly the most important component of your stock market money management principles.
Proper position sizing is key to managing risk and to avoid blowing out your account on a single trade. Position sizing is simply deciding how much you are going to put into any one stock market trade. You can estimate your position size by means of stock market money management, your maximum loss as well as your stop loss. For example, if you have 100K and make a decision to take 10 positions for each entry signal, then you have to invest 10K in each stock. This would decrease your risk as well as will increase your prospect to make a profit as your investment has been diversified. If you are utilizing a proper trading strategy, then you have a probability to get profit in 7 trades and passing in 3 trades as your accuracy would be 70%.
Proper position sizing has two purposes. The first, to preserve your capital and avoid every Catastrophic loss (losses that you will never recover from). This purpose takes priority, and you must never risk ruining your trading account. Its sole purpose is to preserve your capital, the most excellent solution is not to trade at all. The second purpose of position sizing is to maximize the profits.
With a few simple inputs, our position size methods will assist you determine the approximate quantity of currency units to buy or sell to control your maximum risk per position. Without the proper strategy, you just might loose your capital faster than you gain it – sometimes even with a single trade!
Traders, however, consider that they’re doing an adequate job of position sizing by simply having a stop loss in place. While this will tell you when to get out of a stock market position, and with a maximum loss will determine that how much capital you’re risking, it doesn’t resolve the question of how much or how many units you can buy.
If you have already estimated your maximum loss and your stop loss, you can accept these values, and plug them into a formula that will compute how many shares you can purchase without exceeding your maximum loss.
The Equal Dollar Strategy
Each trader uses different position sizing strategy, but of all the different strategies and tactics people use, the equal dollar position sizing strategy is very popular. This method is mostly used by passive investors, as it is an easy as well as efficient means to allocate capital. This strategy basically means that you allocate a specific dollar amount of capital to each trade. The dollar amount is determined by you based on your account size and how diversified you wish to be. With this method, it is best for you to invest a small portion of the total account in each stock, achieving some level of diversification. So in case, if some stocks go down, hopefully some of the others will rise, countervailing the loss. You can read more about at our homepage.
The other strategy which is also very popular is Equal risk position sizing strategy. Equal risk also means risk of equal percentage. It is a strategy which is normally used by shorter-term traders as it involves the use of a stop loss tailored to the stock. Many traders only risk 1% of their account on any single trade. Through this strategy, you can use all your capital and take a short-term trade in one stock, but the stop loss will prevent you from losing more than a specific percentage of your account.
For determining your position size you must set a stop loss level. The stop loss is an order that closes out the trade if the price will move against you and reaches a specific price. This order is placed at a logical spot which is out of range of usual market movements, and if hit, let’s you know you’re wrong regarding the direction of the market.
If you understand the basics of most of the position sizing strategies/ methods mentioned above, then that will move a long way in helping to grow your account as steadily as well as with reduced risk.