Friday Morning Reader’s Choice: A Bit More on Position Sizing

There were a lot of great ideas that came in from all of you about what you would like to hear about, so I am starting a Friday Morning Reader’s Choice blog to address them. The first came from Michael Batnick a request to hear more about position sizing.

Back in October I wrote here briefly about position sizing, describing my rules. Knowing the rules is fine but understanding how they are developed and implemented can give further insight and help refine if they work or not and meet their objectives. Let’s delve in a little further.

Start with the Goals

I stated that my goal was to protect against a crisis and allow for success. That is pretty vague isn’t it? Let’s deal with the first part this week.

Protecting against a crisis means both not risking too much capital and understanding to the best of your ability where the crisis can come from. The second part comes from practice and gaining skill and then the first part is mechanical. As a top down technical analyst this means first assessing the trend, then the influencers to the trend to determine what could change it. If the SPY is rising and the US Dollar and Treasuries are falling then there is a strong tailwind for all equities, for example. But if the Dollar is rising and Treasuries also start to climb then stock prices are at risk. Then looking at the individual risks in the stock. Those risks for a swing trader include the liquidity in the stock, meaning the number of shares that trade and the typical spread, and whether or not there are options to hedge and how liquid they are. A stock with good liquidity and tight spreads in both the stock and options can end up looking better than a stock with a massive move potential but little liquidity and no way to hedge. That analysis along with a technical review of potential support and resistance levels leads to an assessment of how much risk it may take to be in a trade.

A stock in an uptrend in a market that is trending higher with good support from intra-market influencers can be played with greater confidence than the same stock running counter to the market trend.

There is some art and estimation involved in this process of course. It cannot be helped. With this analysis in hand, sizing a trade to never risk more than a small amount of your capital will let you live to play another day. if you only risk 2% then you can lose forever at progressively smaller sizes before you are broke (if the streak gets really long you might consider quitting early though). Defining how much capital is at risk is a bit of an art. Armed with your risk analysis and support and resistance levels, you can determine stop levels. This will define your risk, in theory. But because the markets are not continuous 24 hour liquid markets you are risking more than you think. This is real life. The one exception is when you are buying options. With support on a long trade say $1 below your trigger, then your risk is defined as $1 and you can size your trade according to your capital rules. If you spend 50 cents on an option then your maximum risk is 50 cents.

(continued next week)

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