If you are confused about how much amount should be used in each position while stock trading online or the number of shares you should buy or sell in each trade, it can be done using the position sizing method.
This is the most common method of finding an ideal trade that aligns with your risk profile. In this article, you’ll get to know about its importance, formula, techniques, and benefits along with examples.
What is Position Sizing?
Position sizing is a method of finding the amount of capital to be allocated in each trade, or the number of shares of a particular company to be bought or sold in each trade.
Getting your position sizing in trading right safeguards you from probable losses per trade because it helps you find out the ideal number of shares that you can trade.
Moreover, it is helpful in finding the best profit potential from each trade because if you buy fewer shares than the ideal number then you can lose out on big opportunities.
Of course, position sizing doesn’t just apply to stock trading. You could also use it for finding the appropriate lot size/contracts while commodity or currency trading as well.
Position Sizing Formula
Here is the formula for position sizing:
Position Sizing Formula: Account Risk of a Trader/ Trade Risk of Shares
Account risk tells you how much risk you can take in each trade out of the total amount that you have in your trading account.
The trade risk tells you how much risk you can take from shares over and above their current market price to the level of stop-loss.
Example of Effective Position Sizing
Suppose you have a total sum of ₹20,000 and you can take the risk of 2% which is equal to ₹400 and this is the account risk.
If the XYZ shares are trading at ₹300 and you want to restrict the loss to ₹200. The difference between the current market price of a share and the stop loss is equal to ₹100 which is the trade risk.
Position Sizing Formula = Account Risk of a Trader/ Trade Risk of Shares
= ₹400/ ₹100 share
The position sizing formula tells you the ideal number of shares that you can buy which is equal to ₹400/ ₹100 shares i.e., 4 shares.
Factors to Consider for Position Sizing
Some of the key factors you should consider while calculating the position sizing for any trade are:
1. Risk on Total Capital
The most important factor you should consider is how much risk you can take on your total capital.
The risk percentage should be set as such if you lose that amount then it does not hamper your future goals.
2. Find the Trade Risk
You need to find the trade risk that each trade holds and at what price you want to place the stop-loss.
The larger the difference between the current market price of a share and the stop-loss, the more the number of shares you can purchase.
3. The Volatility in Share Prices
You need to find the volatility in the share prices over a certain period of time using technical analysis. This will help you in considering the risk level of shares in the calculation of position sizing.
4. Number of Trades
You need to keep track of the number of trades you are doing at a point in time. It will help you allocate the money in the best possible way and distribute the risk to each trade.
Common Techniques for Position Sizing
There are many techniques for position sizing. To keep it precise, there are three common techniques for position sizing and here they are:
1. Number of Shares Per Fixed Sum of Money
In this technique, you purchase the number of shares using a fixed sum of money available in your account.
You do not distinguish the different shares on the basis of their risk level and future opportunities.
For example, if you have ₹4 lakhs in your account and there are four shares that are bullish in the market. Then, you will allocate ₹1 lakh to each 10,000 shares irrespective of the risk level.
2. Margin Percentage of Amount
In this technique, you purchase the number of shares on the basis of a particular margin percentage of the total sum of money.
For example, if you have ₹4 lakhs in your account and the margin percentage you decided is 10%, then you will allocate ₹40,000 to every trade irrespective of the number of shares you get.
3. Percentage of Volatility in Share Prices
In this technique, you purchase the number of shares on the basis of the percentage of the volatility in the share prices multiplied by the total sum of money.
For example, if the volatility of the XYZ share taken from the difference between its low and high price is equal to ₹100 and you can take the risk of 3% on your sum, then the amount on which you can take the risk out of the total sum of ₹4 lakhs will be equal to ₹12,000.
After this, simply divide this amount by the volatility of the XYZ share which is ₹12,000/ ₹100 = 120 shares and therefore it is the ideal position you can take.
Benefits of Proper Position Sizing
If you are able to find the proper position in trading, then it can have numerous benefits which are as follows:
1. Helps in Reducing the Risk
Position sizing helps you in reducing the overall risk in each trade. This risk is not static but is the optimal level of risk that you can afford to take.
2. Cost-Effective
You can avoid trading in securities that are not suitable for your risk profile. This technique will also save your capital for any future opportunities and you do not end up going all in, in a single trade.
3. Brings Clarity to Each Trade
This method brings out the clarity in your trade on how many shares you should buy or sell in each trade. You do not end up playing on extremes but rather take the position that is made for you.
Conclusion
Position sizing helps you find the suitable number of positions you can take in each trade based on the account risk and trade risk.
This can be done using various techniques such as the number of shares on a sum of money, the percentage of the amount, and the volatility in share prices.
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