Traders enter the stock market with the dream of making it big someday. Successful traders have been able to meet the challenges in the market and still earned double of their capital or more profit from their trades. However, the capital has to be distributed to minimize the risk faced by a single trade. All the capital can be wiped out if the whole capital is invested in a single trade and that trade goes in a loss.
Position sizing refers to the volume of an investment/position that the trader holds, the number of units/stocks he has in a single stock. It is important to determine this position of the trade as it affects the overall capital and helps to reduce the risks and improve the profits. Position size of an investment can not be randomly chosen by a trader, because he will be mostly delusional about the success of the potential businesses, and becomes subjective which may or may not work out for the good.
Position sizing matters almost in all types of trades. All successful traders in the forex, index, commodities, and stocks market swear by the role of position sizing that has been placed on their trade. Position sizing is not just a random calculation but is a mathematical equation, and considers things like the degree of risk that the trader can take along with the amount of capital he has invested.
There are many models and strategies for position sizing in trading, the goal of all of these being to reduce the risk that the trader should reduce while investing in some trade, no matter how certain the trade success is going to be. Below are a few of the position size methods.
- Fixed Percentage Value: This is the most common method used by the traders to calculate the position size of the trades. The trader will risk a fixed percentage of his total trade. For e.g, if his capital is ₹10,000, then 1% of the same will be ₹100. Also, the bigger the capital grows, the lesser the percentage will drop. E.g. if the capital is ₹10,000,000, then 1% of it will be very huge and that much risk can not be taken by the trader. Here the percent has to be reduced further.
- Fixed Dollar Value: This method of calculating the position size is quite easy. This works so well for people who are relatively new and do not have huge capital. They can simply divide the value of their total capital into a few fractions and can keep each one to trade in different instruments. This way they can minimize the risk of losing the bigger chunk of capital if few of the trades prove to be losing. There can also be other ways to calculate it, for instance just fixing a particular dollar amount on trade, as per the risk tolerance of the trader.
- Volatility: Another method to calculate the position sizing is keeping in mind the volatility factor of the trades. The number of shares or the amount of capital that can be invested in trade is based on how volatile that stock is. This reduces the risk of volatility on the capital of the trader. More capital is allocated to the less volatile trades, and vice versa.
There are many other methods to calculate the position sizing in trading. It is important to recognize the most suitable method for your trading business, based on the risk tolerance and the capital invested, and many other factors involved. But the trader must invest his capital after calculating the position size, to reduce the risk of losing the money, and to distribute the potential loss in trade into a few more trades.