Size DOES Matter

Don’t be fooled, size DOES matter. No, I am not a spokesperson for some completely worthless male enhancement supplement; I’m talking about position sizing! Position sizing properly is a key ingredient to sound risk management if you are hoping to be successful in trading.

If we recall back when I was a genius in 2007 I did in fact start out with an idea of what position sizing was supposed to be. However, this quickly went away when I was doing well and even more so when I was doing poorly. I would think “well I could just make more money if I risked more.” Do not listen to these thoughts, as they will end up being your downfall in the long run.

To determine our position size we first have to know how much we want to risk per trade. This is somewhat a tricky question because it depends on multiple factors including age, capital allocation, trading style and aversion to risk. In general, I would say a reasonable amount to risk per trade is half a percent to four percent.

As I have said previously I risk 2% per trade, which is essentially in the middle of this range. It allows me to be wrong many times in a row without going broke because I never want a trade to make or break my account. As usual let’s look at a real world example shall we?

Here we have IBM, which has had a difficult time getting above the $120 level. With this line as resistance it should be a low risk entry to short as it is rolling over. Since IBM is not super volatile we will exit if it gets above 120.50. For simplicity sake let’s say we are risking $1.50.

As a generic example we’ll say 2% is $1000. If we were shorting it would as simple as solving this equation:

1.50(x)=1000
x=666

This means we could have a position size of 666 shares if we only wanted to risk 2% of our theoretical account. As usual I prefer options so let’s look at put possibilities.

If we think the move will happen fairly quickly we can trade front month contracts of September, which is what these are. Depending on our trading style and preference we could either go a strike out of the money or in the money. For the purposes of learning we will look at both possibilities.

If we choose the 115 put, we have a delta of -.26. We could approach this two ways, smaller position with no stop, or larger position with a tight stop. Since the delta is fairly low, if the stock moved to 120.50 we should only lose .39 on our option. If we were to be conservative, we could just buy a position and risk the entire premium, essentially buying nine contracts at 1.10 and letting it go. This would be our $1000 at risk.

The other way is taking a larger position size knowing that we will likely lose .39 on our option with a 1.50 move in the underlying. If we limited ourselves to 40 cents of risk on the option we could use a position of 25 contracts. This would also give us a risk of 1000 with a higher reward if it works but also higher commissions and potential for a larger loss if it gaps higher than our stop.

The same thing can be done for an in the money option, we just have to look at the difference in delta. A 120 strike has a -.55 delta. We would lose approximately 80 cents if the stock hit our line in the sand. This means we could have a position size of 12 contracts if we bought at $2.80 we would place our stop at $2.00. Choosing the ITM options gives use a little higher probability of being correct and more intrinsic value.

Even though this is somewhat of a dry topic this is essential to learn and something I wish someone had really laid out for me when I was starting out. Hopefully it was helpful!

Disclosures: Long IBM puts