Have you ever blown up your trading or investment account? I have and it sucks. After making a few successful trades in my first self-directed account over 14 years ago, I thought I had things figured out. My next trade was going to be the "big one". With no regard for money management and position size I put on a couple trades and Kaboom! My account went up in smoke.
Watching profits and hard earned money evaporate in a short amount of time is difficult to recover from both financially and emotionally. One or two bad trades should never blow up an account but they can if you don't properly position size.
We all hear the rags to riches stories of that someone who bought a stock, made a "killing" and they're now retired on a beach somewhere. Could this happen to you? Maybe. But it's highly unlikely and improbable. There are far more stories of investor's losing their shirt then there are making a fortune. The problem is you only hear the success stories because most people don't like to talk about their losses. It's embarrassing. Losses are part of the game and keeping them under control is one of the keys to successful investing.
If you've ever bought a stock or an exchange traded fund how did you know how much to buy? How much of your available equity did you allocate to the position? Did you think about what you would do if the stock went down by 50%? What if it went up by 50%? How much would you lose if you were forced to sell?
Position size helps us to stay in a position in order to maximize our gains but more importantly limit our losses and avoid account destruction.
Below are some simple rules for position sizing correctly:
- Never risk more than 5% of your account on any single position. Most active traders will risk far less, closer to 1% on any one trade. For the longer term investor 2.5% is probably more acceptable amount to risk. It's safe to say that 5% should be the maximum.
- Determining when you'll get out for a loss (stop-loss) is needed to figure out the appropriate amount of shares to buy. For example:
Account size: $100,000
Amount of Risk for one position: 2.5% or $2,500
Stock Price: $20/share
Stop-loss: If stock goes down 25% or down by $5/share you will exit the position
Position size = $2,500/$5 = 500 shares
A simple way to remember this is to decide how many points or dollars you are willing to risk from where the stock is currently trading. From the example above the stock is trading at $20 and if the stock goes down by $5 you're going to get out with a $2,500 loss. The math is simple: 2500/5 which will give you the appropriate "position size" or shares that you can purchase which is 500.
- The more volatile the stock the larger the stop-loss that's needed. Stocks that are volatile or have large intra-day price swings (or Average True Range) need more room to move. Getting whipsawed out of a position is a common mistake when position sizing too large or having too tight of a stop.
Following the simple rules above will not only help you sleep at night but allow you to take manageable losses and live to fight another day. Cut your losses short and let your winners run!