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April 24, 2006 at 9:45 am | | Comments 2

How Much?

Compounding money has been called the 8th Wonder of the World. It truly is amazing what can be done when you make regular incremental gains. It is no wonder then that successful active trading should include an understanding of the best ways to size positions properly according to your trading method in order to maximize profitability. I’ve known plenty of brand new investors who had just a small amount of money which they piled into one idea all at once. However, the experienced trader knows better than to do this with his entire trading account, so let’s explore this topic a little further!

I think the best place to start when determining which position sizing method to use is your trading timeframe. The longer your timeframe, the greater your exposure to unexpected events will be, whether they are stock-specific or macroeconomic events. These unexpected events will vary from good or bad, from an analyst upgrade to a terror threat, but it doesn’t necessarily matter because it is still added exposure to risk. Plus, if you trade long enough, you’ll have both good and bad luck when it comes to headlines. The point is that the longer your money is in play, the more risk you are exposed to, so your timeframe is the most important consideration when it comes to position sizing or ‘how much’ to trade.

As for active trader timeframes, they primarily include day trading and swing trading. Although you might have your own hybrid approach, for purposes of this discussion we’ll look at those two.

In my own trading, I have a mixed approach based upon my timeframe. For my day trades, I prefer to use the Percent Risk model outlined in Dr. Van K. Tharp’s book, Trade Your Way to Financial Freedom. With this position sizing method, I predetermine the percentage of my account which I am willing to risk or lose (‘R’) per trade if I am wrong. I then let the chart patterns dictate my stop loss levels, and then trade the appropriate amount of shares based on these variables. (Here is a nice calculator for determining position size, I use the “Dynamic Position Size” calculator for my day trading.)

A day trading approach offers greater leverage (for designated day trading margin accounts – $25,000 minimum requirement) in the form of 4-to-1 buying power. Trading larger positions on a day trading basis with such leverage on a shorter timeframe can help offset the returns produced by holding smaller positions for multi-day moves. When I’m day trading, I will set my ‘R’ (% of my equity at risk for each trade) generally at 1%. This just happens to be the level which I’m comfortable with, and may vary from your own preference. I’ll adjust that percentage up or down slightly if I’m trading better or worse than normal, raising it to 1.5% if I am trading exceptionally well and am trading in sync with the market, or reducing it to .5% if I am in the midst of a drawdown. The idea is to have a good starting point and then tweak it slightly to maximize your results (or minimize damage).

I am primarily a swing trader, however, and my swing trading position sizing approach is somewhat more basic. Because my timeframe is longer for swing trades and I am exposed to more risk as a result of holding positions overnight, I base my positions on a percentage of my account equity which I’m comfortable with. I will hold up to about 10 stocks at a given time, and because I don’t know which stocks will move best and which won’t, I allocate equal funds to each swing trade. This is nearly the same as if I were to simply reduce my ‘R’ and trade the Percent Risk model, but it just a bit simpler for me. The result is that when I have fewer trading ideas and am not very active, I am left with plenty of cash on hand (which is a good thing in a choppy market). When things are moving well, I will use margin to either trade larger or add more positions to increase my exposure and capitalize on the improved conditions. The reason why I swing trade this way is because the percent risk model for my ‘R’ of 1% will mathematically limit the number of positions I can put on using 2:1 (overnight) buying power, regardless of account size. So, I do my best to allocate equal funds to each trade and then let the law of large numbers play out in my favor.

Many different position sizing methods exist, so be sure to examine other ideas as you seek the right approach for your needs. I would also point you to Trader Mike, who has an excellent post about position sizing which summarizes a few position sizing methods very well. In addition, Mike’s post is followed by links to several very useful position sizing resources, so check it out.

Your trading method is important as you select trading candidates, timeframes, and entry and exit levels. In the end, though, you’ll want to find the balance between minimizing your risk and maximizing your profitability, and your position sizing will dictate that.

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Jeff White
President, The Stock Bandit, Inc.
www.TheStockBandit.com

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