Hi, this is your Trader of Stocks. What I present here is an effective bottom-up position sizing approach. Improve your risk management by learning to calculate the position size based on your maximum risk allowance and a logical stop loss level of the chart at hand.
What is position size in trading?
The position size is the percentage of equity you are willing to allocate to a single trade idea. Simple as that. The real question is how to calculate a proper and sensible position size?
It makes me sick when traders ‘sell’ their awesome stock picking techniques as an ‘all you’ll ever need package to make a fortune’ and then go on to oversimplify or even neglect portfolio management and position sizing techniques for no reason.
Anyway, the typical trader takes great care of stock selection and focus most of his/her effort on handling each individual stock. The remaining fraction of the attention is then spend calculating the number of shares to buy or sell depending on a preset goal position size arising from oversimplistic and -often times- flawed diversification guidelines.
If that paragraph above describes your approach you are clearly doing it wrong and should read on in order to lift your trading to the next level.
In this article I am about to show you that logical and sensible position sizing isn’t rocket science!
The position size must always be a result of the price and volume history of the underlying individual stock. You can’t impose generalized and rigid position sizes onto individual stocks, they just don’t fit!
What I present here is a straight forward and sensible bottom-up position sizing approach which you better implement immediately if you are still sticking to pointless fixed values (such as the infamous 7%).
Here is a short summary of the technique in advance. Please share to deliver others from the burden of infant-level position sizing!
Let the individual behaviour of each stock provide you with a logical position size to trade with.
How does that sound?
The 5 Steps to calculate position size in stocks
- Find Logical levels: Find logical chart based levels for a stop loss (risk) and intermediate term price target (profit)
- Validate Profit Potential: Check if the trade provides your desired profit/risk ratio aka risk-multiple (read more about the goal profit/risk ratio)
- Calculate Position Size: Divide your maximum risk (%) per trade by the stop loss (%). (read more about Maximum Risk)
- Validate Size: Cut back if the calculated position size exceed your maximum size. (read more about Maximum Size)
- Calculate Shares: Multiply position size (%) with account balance (USD) and divide the result by the current stock price (USD). (read more about using the correct account balance)
Now let’s go through the individual steps in detail.
First Step: Place your stop loss and price target
So you found that nice stock which flashes a clear entry signal according to your rules. Here is what you have to do in order to get the ideal position size to trade this particular equity.
Let’s take MDB as an example. The stock is extended and is actually not flashing a proper entry according to my rules but imagine if it would. This one isn’t cherry picked but was just the first one on my watchlist. It helps to illustrate that this position sizing technique is universally applicable even if the actual trade would not be worth going for it.
Identify strong levels for a reasonable stop loss
First things first you open the chart to check if there is a logical reference level for placing a stop loss. For me that typically means that I check the distance to widely followed moving averages, technical horizontal support and resistance lines and Peak Liquidity Levels (PLL).
The black horizontal lines in the graphs above are technical support levels which you can simply draw directly by eye. Don’t think of them as precise absolute values but rather zones.
The green lines are Peak Liquidity Levels (PLL) which are drawn with reference to the peaks in the volume-by price chart overlay on the left side.
We also have the 10 and 50 day simple moving average (SMA) and the faster 21 day exponential moving average (EMA) as references for price.
In this example the first two price levels which are likely to give the stock some support are located at the first technical support (black breakout pivot line) and/or the little PLL (upper green line). You should always place your stops a little bit below potential support and not directly at the mark.
There aren’t many secrets in trading but here is one of the few I want to share:
PLL is always a stronger support compared to the pure horizontal technical lines. The fact that this PLL support is typically located below the technical support is the main reason why so many traders are taken out by shakeouts. They place their stop slightly below the technical pivot to give it some “leeway” while in reality they placed it right at the PLL.
Please be aware that in the case of MDB the first PLL support is weak but we have to go with it as it is already 9.3% below the current price.
Identify realistic short or intermediate term price targets
The next step is to identify potential resistance levels above and use them as a rough price target. When a stock trades in fresh all time high territory you can often only use a sloped trendline, i.e, the clothesline shown here, or meaningful price tags such as 100$, 200$ and so on. In the case of MDB we have the prior all time highs 12% above the current price and the clothesline 36% above the current price. I always estimate the distance to the clothesline a couple weeks ahead in order to get a more realistic reading.
If price advances faster then expected you have to adjust your trade on the fly but that is beyond the scope of this article.
This graph shows the various levels we identified for MDB so far.
One could also think more short term with a pure technical little stop loss like this. However this is certainly not my style!
In this case the 10d MA is right below the stop and you can easily be taken out by a quick shakeout.
MDB isn’t in a good position and the trade would not be worth going for. Stops can be placed much closer to the current price if a proper setup is at hand.
Second Step: Check if the profit potential validates the trade idea
The next step is to figure out whether the trade idea is good enough for the system you are running. Depending on your winrate you need a specific profit/risk ratio per trade in order to turn out net profitable in the end.
The origin of the famous 7% stop loss rule:
A well known and widely followed profit / risk ratio (price target / stop loss) is 3. The reason for this is because traders of the past studied the price moves between larger consolidation areas and they observed that growth stocks tend to advance roughly 20% on average before they pullback and form the next consolidation. They also observed that price often pulls back roughly 6% from the pivot breakout line.
The logical conclusion was that you place your stop at least 6% (7% for some leeway) below the entry at the pivot and your price target 20% (21% for some leeway) above the entry at the pivot.
If you divide 21% by 7% you get the famous ratio of 3.
While this ratio is meaningless if you don’t enter stocks on base breakouts at the pivot line, it is nevertheless a good starting point if you don’t know your system well enough due to a too short trading history.
With my own win rate I can go with a ratio 2.3 but for this example let’s assume that we would need a ratio of >3 to validate the trade idea.
Back to our example MDB.
Here we have a high profit potential of roughly 36%. So the three potential stops at -3.8%, -6.5% and -9.3% give us profit potential ratios of 9.4; 5.5 and 3.8 respectively. All three are above 3 so all three are valid trades for us. Always try to go with the strongest potential support. Here this corresponds to the -9.3% stop loss located slightly below the upper PLL. Remember that MDB is trading in the middle of nowhere here.
But this example shows that you can apply this technique all the time even when a stock isn’t in a buyable spot.
The trade from the last graph above is also valid (12% / 3.8% >3). Again, this doesn’t make it a trade worth taking. MDB is not providing a proper entry setup according to my style here.
Third Step: Calculate position size via your business risk
MDB gives us the following two valid trades. One is pure technical and short term, while the other is more mid term.
Trade A) Target +12%; Stop loss: -3.8%; Risk based profit potential: 3.1
Trade B) Target: +36%; Stop loss: -9.3%; Risk based profit potential: 3.9
In order to figure out the position size you first have to set a maximum risk (business risk) you are willing to lose on any trade beforehand.
Depending on your account size, reasonable values for your maximum risk per trade would be 3% for accounts <50k; 2% for acccounts below 300k; 1.5% for >300k and 0.5 – 1% for >1M. But this depends entirely on your own risk allowance of course. Learn more about diversification for active stock traders here.
However in almost all cases you better learn how to calculate a reasonable max risk to reduce the probability of large drawdowns.
You can also use our Max Risk Calculator:
Let’s say your max risk is 1.5% of your total equity. This means you size your positions in way that your stop loss hits always translate to 1.5% equity hits.
This is what you would get:
Trade A) 1.5% / 3.8% = 0.39
Your max position size for this trade would be 39% of your account balance.
Trade B) 1.5% / 9.3% = 0.16
Your max position size for this trade would be 16% of your account balance.
From what I wrote about diversification you know that it makes sense to hold at least three stocks in your portfolio to be fully (100%) invested. This translates to a maximum position size of
100 / 3 = 33%.
In the case of Trade A you therefore have to go with 33% instead of the 39% you calculated.
If you rather hold 6 stocks to be fully invested your max position size would be
100 / 6 = 16%.
In this case (6 holdings max) you have to roughly halve the size of trade A in order to adhere to your max position size. If you had taken the calculated size of 39% above, your business risk would still be 1.5% but you would be vulnerable to a black swan event in that particular stock. A black swan can be anything from a news driven overnight gap down, badly timed dilution or generally a severe price drop without any warning in advance. Trade B however allows you to trade exactly your business risk of 1.5% with a suitable position size of 16%, no brainer.
My in-depth article about money management clarifies which account balance you should use for the calculation of your position sizes. Is it the total account balance or should you rather exclude open profits to run your portfolio a little more conservative? Open portfolio heat is an important part of our defense and is covered in detail as well.
Evaluating profit potential or price targets isn’t an exact science. If the stock trades at fresh highs you can typically neglect it but if there is resistance above, it doesn’t mean that you have to exit there. I often go with tight stops so that a +10% move already exceeds my desired profit/risk threshold. Read more on how I use such a profit/risk method but still allow for bigger wins.