How to Bet - Guide to Position Sizing

"When you take up a sword, you must feel intent on cutting the enemy. As you cut an enemy you must not change your grip, and your hands must not "cower"."  - Miyamoto Musashi, 1645

  Have you ever had a situation when you buy two similar looking stocks, place the same bet ... and then see one of them go up as the other go down. The extent of both moves look pretty similar on a chart, but (o, horror) your loser is down way more than your winner is up. The scale of the chart played a trick on your eyes and got your position sizing all screwed up, my friend. There is no easy remedy for this problem, since we don't know the future and can't tell in advance how far and how fast things will move, but here are some guidelines to help along the Way.

There is a concept of 'R', popularized by Van Tharp in his own books, that simply states that you should risk the same dollar amount on each trade and adjust position size accordingly. I encourage readers to further explore this topic on their own, as I don't find it applicable to small accounts (less than 1 million), but the basic idea is valid, no doubt. Specifically, it was mathematically proven that traders should not risk more than 1% of their equity on any one trade. This way 100k account will risk $1000, and 20k account has to allow for only $200 risk per position. It’s a start, but still doesn't tell me how much to bet. I want to put out a line big enough, so the win will be meaningful; split the wad down enough, so to buy all I need; keep it modest enough, so not to blow a hole in an account. Decisions...decisions...

Let’s look at a market of stocks. There are about 2000 active tradeable stocks in the US market (price over 5, average volume over 300K). The vast majority will move 1-5% per day on average and shoot 10-30% over a period of few months, so this is what we need to be ready for. Think about it this way: if I can risk 10% to make 30%, I can lose three times, win once, and still be okay. Dollar-wise, $3000 position will win or lose $300 to $1000, which is a great news for a 100k account, because 3-4K positions size will allow me to have 25-30 positions, so I can run a diversified portfolio (which is what I want). I found that position size of less than $2000 is absolutely impractical, because costs (commissions) really cut into any profits and accentuate losses to a point of erasing any positive results into zero or worse. Therefore I decided to call $3000 (up to $4000 for less volatile stocks) my Standard Position Size and try to stick to sensible securities to avoid wipe-outs.

I don't want to lose a thousand dollars! A $3000 position has to go down $30% to lose $1000. Are you kidding me? Is this what I am doing here - losing thousands? NO WAY! Let’s agree that 30% is a catastrophic loss, from which there is no recovery (trust me - been there, done that). A rational operator should never allow such big loss to develop. As a matter of fact, I don't want to risk more than 5-7% on single position, with 10% as a meaningful pain threshold, 15% will have me cry in fetal position and 20% loss takes me out no matter what. Now I am risking 0.5% or less of my total 100k account on each trade, the pressure is off. Not one single trade can hurt me. They all are about same small risk, ready to deliver big rewards. In words of famous Ivan Krastins: "Just one of the next thousand trades."

I think the problem of under-capitalization is the #1 source of small investor’s dismal performance. This curse plagued yours truly on several occasions. There has to be a clear understanding of what is possible or feasible with $20K account, as risk limitations get quite severe. First of all, 5-7 positions of the same Standard Position Size will have a really hard time to offer much diversification. Secondly, at 10% stop loss on $3000 position we already risking more than traditional 1% of portfolio. Quite a dilemma, eh. I managed to develop several methods that can deal with smaller accounts and will publish them all in due course. There are Ways to 'cut enemy' strongly as intended, without 'cutting up' an account in a process, but of course 'more money' is the best remedy for 'no money' problem. He-he

Every portfolio, method or system I publish states clearly how much money in how many positions it needs initially and whether these assumptions were derived by tests, simulation or real world results. It is important to understand that these are minimum amounts and can be easily multiplied ten-fold without any changes to order execution. It is designed this Way for my own use. Keep in mind, that I don't give investment advice, just Show What I Do (SWID post link), so a patient reader can learn and make pragmatic decisions.

 Proper betting and conservative risk management are crucial for investment success and survival. If done correctly, any one screwed up trade won't make any difference in the long run, but a wrong position sizing will burn thru a portfolio like a wildfire.

I will have more about all this in the near future.
Meanwhile, in the words of a great swordsman: "You must practice diligently in order to understand how to win". Practice...