Position Sizing for Optimal Results - Excerpt from Think and Trade Like a Champion by Mark Minervini
From the best-selling book Think and Trade Like a Champion
May 31, 2017
One of the most frequent questions I’m asked is how to determine the correct position size per trade. Ultimately, this becomes a discussion of how many stocks to hold in a portfolio. While it’s true that the more concentrated your portfolio, the bigger gains you can make in a shorter time, it depends on whether things go your way.
The first rule is to never put your entire account into just one stock; that would be taking too much risk. If you have hopes of making a short-term killing by risking it all, you’re liable to be the one killed! If there’s even a 1 percent chance of ruin, it’s an unacceptable risk. Remember, you’re not going to make just one trade.
Even if there’s a 1-in-100 chance of a catastrophe, that misfortune becomes a certainty, because you’re going to make at least 100 trades, and probably thousands of trades, during your lifetime. Each time you risk it all, you are essentially tempting fate.
On the other hand, if you want to achieve superperformance, diversifying your portfolio too much is counterproductive. Diversification is a tactic used to distribute investments among different securities to limit losses in the event of a decline in a particular security or industry. The strategy relies on the average security having a profitable expected value.
Diversification also provides some psychological benefits to singleinstrument trading since some of the short-term variation in one instrument may cancel out that from another instrument, resulting in an overall smoothing of short-term portfolio volatility.
Your goal should be optimal position sizing. The size of your position should be determined by how much equity you stand to lose if a trade goes against you. Let’s say you have a $100,000 portfolio and you put 50 percent ($50,000) into one position. With a 10 percent stop, you cap your loss at $5,000. But that’s 5 percent of the total equity of your account—and that’s too much risk. If you were to suffer a string of such losses, you would put yourself at risk of ruin.
Instead of arbitrarily picking a number, your maximum risk should be no more than 1.25 to 2.5 percent of your equity on any one trade. The less experienced you are, the less risk you should take on because you are at or near the bottom of the learning curve and more prone to mistakes and losses.
To understand more about how position size affects your risk, let’s say you have a $100,000 portfolio and commit $25,000 (25 percent of your account) to one stock. With a 10 percent stop, you’re putting $2,500 of equity at risk if you lose on that trade—or 2.5 percent of total equity. That’s at the high end of the range for ideal exposure.
If you want to lower your exposure you could tighten your stop to 5 percent, putting only $1,250 or 1.25 percent of equity at risk. If you wanted to keep your 10 percent stop, your only other choice to reduce equity risk would be to cut down the position size to $12,500 (12.5 percent of your account), thus reaching $1,250 or 1.25 percent of equity at risk.
Either your stop moves or your position size moves. One or the other must be adjusted to dial in the correct amount of risk. For argument’s sake, if you wanted to be very aggressive and put 50 percent of your account into one position, you would need to use a 5 percent stop to contain your risk as a percentage of equity to 2.50 percent. But the tighter your stop, the more likely you are to get stopped out.
The key is to find a balance between an acceptable position size and a stop that allows the stock’s price to fluctuate normally without choking off the trade. This is known as backing into risk.
For more on this topic including charts and examples, read Think and Trade Like a Champion by Mark Minervini - available on Amazon.com