How to Position Size and Allocate Capital

Posted on by lindsay

Today the Trader’s Blog welcomes back Marc Nicolas of TradingEmini.com. In previous posts Marc has shared invaluable trading concepts on risk management and using runners to increase profits. Today will be no different as he discusses the often overlooked method for calculating proper position sizing to stay in the game by taking into account your total risk capital and stoploss level.

Visit TradingEmini.com to learn more about trading psychology, money management and Marc’s trading strategies.
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In my 17 years of trading and having traded for a hedge fund, it is Proper Position Sizing and Capital Allocation which has kept me consistently in the game as a professional trader. Even if you have a great trading strategy, if you do not understand how to properly size your positions, you are unlikely to achieve a comfortable level of consistency and you risk blowing account after account. Proper Position Sizing and Capital allocation protects your risk capital by determining how big a position you should take on any one trade. This will mean fighting the urge to buy an arbitrary number of shares because you “feel” a trade is a sure winner. It is the bridge between your chart analysis and risk management plan. Unfortunately position size is the most overlooked aspect of trading and yet is the most important aspect, especially with the volatility we have seen in the markets lately. I hope the 4 steps below will help you.

• Step 1: Capital Allocation

This calculation will split your capital according to the number of different positions or instruments, like futures, stocks, forex, commodities or options you want to trade, or hold in your portfolio. For instance, assume that you have $100,000 Total Risk Capital and you want to include 5 different positions in your portfolio to diversify your risk. Your Instrument Capital Split should be Total Risk Capital/Number of Positions, in this example, $100,000/5 = $20,000 is the capital allocated to each position.

Usually what traders do now is incorrectly take the $20,000 Capital Allocated and divide it by the price of the stock and buy that number of shares. For instance if Microsoft is trading at $27.50, $20,000/$27.50 is 727 shares. This is a mistake because it does not take into account your Stoploss or Capital Risk %. For instance if you did this for each of the 5 positions you would be risking a maximum size and not taking into account stoploss or Capital Risk %. Step 2 illustrates how to incorporate your Capital Risk %.

• Step 2: Maximum $ Risk Per Trade

You should only ever risk a certain percentage of your Total Risk Capital on any one trade/position. Since 2001 we have been suggesting 1% or less, especially in the beginning. 1% because it allows you 100 consecutive loosing trades before you blow your account so you have plenty of time to maneuver and you don’t become emotionally attached to any single trade or position. So for each instrument your Maximum $ Risk Per Trade is 1% x Capital Allocation, in this example, 1% x $20,000 = $200 is the maximum amount you should risk on each allocated position. Next, before calculating the optimum shares to hold, in addition to the 1% rule, you should incorporate the last factor, a Stoploss Level.

• Step 3: Stoploss Level

This step is critical. You must base your Stoploss on your charts and personal trading process, not an arbitrary monetary level. So assume that your chart technical analysis and trading strategy is showing you a long signal for Microsoft, which is trading at $27.50 and that signal will no longer be valid if price goes below $26.10, so you decide to set your stoploss at $26.00, risking $1.50 per share. Now you know you are prepared to risk $1.50 per share, and you have your 1% risk of $200 from step 2, you can calculate the optimum number of shares to buy for the allocated position using the formula in step 4.

• Step 4: Optimum number of shares to buy on each instrument incorporating a predefined Stoploss Level and predefined Capital Risk %.

To calculate the maximum optimum number of shares to buy you take the formula:

Maximum $ Risk Per Trade/Stoploss Level = Maximum Optimum Position Size.

In this example, $200/$1.5 = 133 shares. This is a much safer number of shares than the 727 shares at risk from step 1. This is how the hedge funds and pro traders correctly position size and even if you have a personal trading strategy which is not optimal these position size principles will keep you safer, and this is very profound – even with a bad trading strategy, the mathematics of proper size position will keep you in the game longer than if you have a great process but apply it with poor money management, stop loss and optimum position size principles.

Also because you know you are only risking a small percentage of your capital (1% or less) on each position your trading will become less stressful and be based on your charts and trading process, not your emotions, consequently you have a much better chance of achieving consistency and staying in the game for the long-term.

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Visit TradingEmini.com to learn more about trading psychology, money management and Marc’s trading strategies.

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***The views and opinions expressed in this post are that of the featured Guest Blogger. This post does not necessarily reflect the INO.com’s own views. All trading involves a level of risk. Individuals should fully understand risks before entering the market. None of the information contained in this post should misconstrued as advice or any sort of solicitation to buy, sell or otherwise invest in any fund, company or security. ***

18 thoughts on “How to Position Size and Allocate Capital”

  2. Totally agreed! That's why forex rookies with a $500 always blow up! There is no possible way to enter a position risking $5, so their risk is always extremely high in respect with their account sizes

  3. It's a great article, I could never figure out how many shares to buy or where to stop loss.
    But there is one more dimension to add to allocation and risk management, it's a matter of timing, too. If you were into the volatile markets lately, long on 5 various stocks, you would have lost the 1% on maybe all 5 trades, while if you were long in any 5 stocks in october last year, maybe you would have won on all 5 trades. So I think the idea is not to do more trades at the same time like Marc Nicholas suggests, but stay in cash and wait to resolve each of the 5 current trade before going on to the next trade for each sector of your allocation.

  4. great insight & thoughts !! proper money monagement in trading is the key for success!! been burnt myself before for takin too much risk, i now take it very seriously as should every trader! thanx for these great rules !

  6. If you want to be in it for the long term, you need to take into account the information in this article and make it part of your daily routine. Without proper position sizing you will eventually blow your account up. Thanks for the great article, Marc.

  7. moderation is not mt strong spot ! if i like it alot im 100% on it ! not all in like poker - lose all the market can only take part of your winnings if you lose !! jamie gold alias BOB

  8. This is a great article. The most important skill to learn in trading, capital allocation and management. Read it and learn it.

  9. This Article addressed the number one and the most important aspect in trading and investing. Proper capital and risk management. Since trading is a probability game. Traders need to learn proper funds allocation to make sure trading account is not wiped out in one trade. It goes hand in hand with trading psychology and technical analysis . This free information is very crucial to trading and hearing it from a veteran traders makes more sense.

  10. Hi Rick good question, my take on it:

    Option 1: If in the example above you fully vest each 5 positions of your total capital available using the steps above then I would keep the balance in cash, because you will be risking $200 (1% per $20k) per position * the 5 positions = $1,000. So if you loose on all 5 positions its only 1% of your total capital ie $1k on the $100k=1%.

    Option 2: If you only vest in that single position, with that $20k allocated capital and risking $200 on the MSFT trade, you can re-deploy the cash balance, the $16.4k in your question. I would do the exact same steps as above, or more aggressive, this is personal preference, and risk another $164 (1% of the $16.4k). Then my total risk would be MSFT risk amount $200 + new position risk amount $164 = total risk amount $364, still only 0.364 % of my total $100k capital available making very safe and so on.

    So the key is, are you fully vested on all 5, $20k positions, or partially, in which case you can do the above steps again and again .

    Hope it helps
    Marc

  12. Good article but I'm confused. If I have $20,000 to invest and only buy 133 shares at $27.50 per share then I invested $3,658. What do you do with the remaining $16,342 that I have to invest, leave it in cash?

  15. Good article, you are so right that solid risk management like position sizing is too often overlooked

  17. The author's strategy for allocating risk capital, especially the 1% loss rule, might last for a week in these volatile markets. The stop loss orders would all be discovered and triggered by HFT systems and the broker would smile at the commissions earned as his carefully allocated lots sold out. Thanks for playing in our game Mr. In-duh-vidual investor. To play again, drop in another quarter.

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