Trade Risk Management, Part 1: Position Sizing

How many stocks should I hold in my portfolio? This is what position sizing is about. Let's consider some extremes in position sizing. At one extreme, an investor could hold just one or two stocks in their portfolio. This would clearly be very risky, as individual companies can collapse or go bankrupt, as seen from examples such as Bre-X, Nortel Networks and Lehman Brothers.

At another extreme, an investor could hold 50 stocks in their portfolio. This would significantly reduce the risk of losing money from one company but would also involve a lot of effort — to screen companies, stay on top of quarterly earnings reports and move in and out of positions. This is where position sizing comes in. Position sizing is about balancing risk, reward and effort as part of your trading strategy.

A few definitions before we begin:

Many investors divide their efforts between a trading portfolio with a shorter time horizon and an investing portfolio with a longer time horizon. The focus of this article is on a trading portfolio.
Position sizing consists of two questions: how many positions to hold and in what weights. The focus of this article is on how many positions to hold; we will assume that positions are held at equal weight.

A framework for trade risk management

A risk-based trading approach starts with making a decision on trade risk and then managing that trade risk based on stop orders and positions.

Below are definitions and examples of ranges for each of these points, applied to a trading portfolio.¹ Ranges are included for illustrative purposes only; actual ranges for trading depend on an investor's objectives, risk tolerance and overall approach to investing and trading.

Trade risk: Overall risk of loss to the trading portfolio from a single position, range from 1.25% to 2.50%.
Stop orders: Acceptable loss before selling, range from 5% to 10%. Average loss preferably at lower end of range.
Positions: Number of positions, range from 5 to 20. Again, this is for a trading portfolio. Investors often choose to hold a larger number of positions in an investing portfolio.

Now let's explore some examples of trade risk, based on a trading portfolio of $100,000 and 10% stop, with varying position sizes:

	5 positions	10 positions	15 positions
Portfolio size	$100,000	$100,000	$100,000
Position size	$20,000	$10,000	$6,667
10% stop	$2,000	$1,000	$667
Trade risk	$2,000 divided by $100,000 equals 2%	$1,000 divided by $100,000 equals 1%	$667 divided by $100,000 equals 0.67%

This is just one way of showing that investors can manage trade risk by adjusting stops and positions.

Exploring ranges for trade risk management

Let's explore the ranges we've outlined above, to show the reasoning behind a risk-based approach to trading.

Trade risk: 1.25% to 2.50%

If the range were much higher, then a string of losses could reduce wealth in short order. This risk can affect even more experienced investors. Of course, the range could be lower, although this would imply tighter stops or more positions. The point to a risk-based approach is to start with a given level of trade risk, then adjust stops and positions accordingly.

Stops: 5% to 10%

To be clear, stop orders do not guarantee that a loss will be contained. For example, a stock might close the day at $100, release a horrible earnings report after-market and open the next day at $70. Here a 10% stop set at $90 would be ineffective; instead the stop would activate at the first available price of $70. This is known as a "gap down". Investors may reduce the risk of experiencing these sharp losses by keeping stops within a moderate range, recognizing that large losses tend to start as small losses.

Setting stops too tightly, however, may not give a position much room to run, since stocks do not typically move up or down in a straight line. Stops can be "hard" — where the investor sets a trailing stop-limit order that sells automatically — or "soft" — where the investor makes a note of a target price level and decides whether to sell when the price reaches that level. For an overview of hard stops, see our article on trailing stop-limit orders.

Positions: 5 to 20

As mentioned earlier, the lower end of the range reduces the risk of ruin from holding one or two names, while the upper end of the range recognizes the limits of time and effort needed to monitor and adjust positions in a trading portfolio. If investors are happy with trade risk and stops, then position sizing will more or less suggest itself. As an additional way of managing risk, experienced investors tend to enter positions in phases rather than all at once, to see if the market agrees with their trade before adding to the position.

What influences trade risk management?

So far, we've outlined an approach to trade risk management, relating to how investors manage risk in a trading portfolio. But trade risk management is ultimately part of an investor's overall approach to risk management. Trade risk is strongly influenced by an investor's risk tolerance, as well as how risks are correlated across the investor's portfolio.

Risk tolerance

A key factor that affects risk management is the investor's risk tolerance, which consists of their ability and willingness to take risk. Ability to take risk may be affected by the purpose of the trading portfolio and its size relative to the investing portfolio. An investor may find it easier to take risk when the trading portfolio exists to fund a discretionary goal such as a dream vacation, or when the trading portfolio is relatively small compared to the investing portfolio.

Willingness to take risk may be affected by the investor's level of experience. It is likely safer to assume a lower level of experience until the investor has made some mistakes and learned from them, and preferably has made these mistakes during a variety of market conditions. Like a pilot, how an investor deals with turbulence is a good sign of experience.

Correlation

Another factor that affects risk management is correlation. We've discussed trade risk as the overall risk to a trading portfolio from a single position. However, during a market crash, many or all positions in a trading portfolio may trigger a stop-loss sale at the same time. When setting stops, investors may want to consider the suitability of the stop level, in the event the entire trading portfolio were to be sold at that level.

Investors should also consider correlation between their trading and investing portfolios. Some investors may hold portfolios that appear to be different on the surface — for example, high-growth stocks for trading, versus dividend-paying or lower-volatility stocks for investing. In a market crash, however, correlations between stocks tend to converge and an investing portfolio may be just as risky as a trading portfolio.

Key takeaways

With a risk-based approach to trading, investors start by setting their desired level of trade risk, informed by their overall approach to risk management, then adjust stops and positions to reflect this level of risk.
Investors who prefer to take more risk may decide to set a higher range for trade risk, including looser stops or fewer positions.
Investors who prefer to take less risk may decide to set a lower range for trade risk, including tighter stops or more positions.

¹ Examples of ranges are adapted from Mark Minervini, Think and Trade Like a Champion (Access Publishing Group, 2017).

Trade risk management, part 1: Position sizing