Money Management in Trading: Position Sizing

The terms "Position Sizing" came across to my trading journey when I read van Tharp's book, Super Trader. In his book, he stresses the importance of knowing "how much stocks to buy" to stay alive in trading. This theory of position sizing really struck me hard! This is essentially the MONEY part of the famous 3M theory.

The theory is this: Assuming you have a very good EDGE (or strategy - be it an algorithm, some technical analysis or fundamental analysis, or any strategy) that will give you a positive return in the LONG run, you have to be careful with your money management. I mean, you are sure that your EDGE (METHOD - another M in the 3M) will give you WIN over time, BUT you do not know the SEQUENCE! For example, you can have a straight ten losses before getting a big win on the eleventh trade. You wont know when you win, you wont know when you lose. Moral of the story: you have to play SMALL to stay in the game for LONG!

Simple theory and very logical, eh?

So the question is how SMALL you should buy? In his book, van Tharp mentioned about several ways to position sizing, but in this article, I am going to tell you the formula I am using with a great discipline (well, I am still in the game!)

The elements you need to define first:

1. How much is you current base capital (C)? In my formula, this is my total capital including those open position in the market.
2. How many percent of this C you want to risk (R) in a single trade? It means that, if you R is 1% and you C is USD 10,000, your allowable loss in a single trade is USD 100.
3. How many percent is your cut-loss (L)? I use fix percentage as it is easier to compute. Depending on stock market I trade, I use between 8-10% cut loss.
4. What is your buying price (B)? 
5. The final piece of the equation is how many stocks - position sizing (P) - you are allowed to buy.

Hence, the full formula is as follow:

P = (C*R)/(B*L)

Example #1,

Stock XXX price is at USD 1.5, your capital in your broker account is USD 20,000. In you trading plan, your cut-loss is at a fixed percentage of 8% and you can only tolerate 1% loss of your capital in one trade.

P = (20,000*1)/(1.5*8) = 1,666 stocks (round it down, to the nearest lot)

Example #2,

Stock XXX is at SGD 1, your capital in broker account is SGD 5000, and your open position is SGD 200, your cut-loss is at 10% and you are very conservative and only willing to risk 0.5% of you total capital. You are in Singapore market where 1 lot is 1000 shares.

P = (5200*0.5)/(1*10) = 260 stocks (round it down, to the nearest lot). This does not meet 1000 share minimum to buy 1 lot, so stick to your trading plan, and DO NOT buy the stock.