Position Sizing: How to Use it to Exponentially Grow Your Profits 

Welcome back everybody, today we’re getting into a topic that I absolutely love and literally will help determine if you’ll be a winner or loser in your trading, it’s THAT IMPORTANT!

Many traders, as well as many top professional traders, do not realize the most important, non-psychological component of trading & investing success, POSITION SIZING!

A Position Sizing Strategy helps you determine how much equity to risk on every trade you take.  Its purpose is to help you meet your objectives.

You could have the world’s best trading method (for example, one that makes money 95% of the time and in which the average winner is twice the size of the average loser), and you still could go bankrupt if you risked 100% on one of the losing trades.  

Position Sizing Strategy helps you determine how much equity to risk given several inputs; your trading strategy’s risk, your personal risk tolerance, the kind of returns you want to make,and your own personal definition of ruin – whether that’s bankruptcy or some level of equity drawdown.

1.) Traders’ Objectives:  everyone has different objectives when he/she trades. You must determine what your personal objectives are.
2.) Trader’s Psychology:  this influences the first component (the trader’s objectives).  

  • What are your beliefs about your trading? 
  • What emotions come up when you’re trading? 
  • What’s your mental state?

3.) Position Sizing Method:  for a lot of traders, this is intuitive.  In other words, they really don’t have an actual method or particular algorithm.  You really need an exact method of position sizing. 

A trader with NO Objectives and NO Position Sizing guidelines will position size TOTALLY by emotions.

Let me give you what I personally use…

Position Sizing Model

A simple model for determining HOW MANY POSITIONS involves risking a percentage of your equity on every trade.  You need to know three distinct variables: 

The CPR Model for Position Sizing

  1. How much of your equity are you going to risk?  This is your total risk, but we will call it Cash (or C) for short.  This will be the C in our CPR formula.  For example, if you were going to risk 2% of your equity, C would be 2% of your equity.  If you have a $25,000 account, C would be 2% of that, or $500.

  1. How many contracts/lots/shares do you buy/sell (that is, what is your position sizing method)?  We call this variable (P) for Position Sizing method.  Which stock/ETF are you trading and how many shares do you buy/sell?

  1. How much are you going to risk per contract/lot/share that you trade?  We will call this variable (R), which stands for Risk.  For example, if you’re going to buy the E-mini S&P 500 at 1239.50 and your risk is 3.00 Points or 12 Ticks (1236.50), then your risk R in this particular trade is $150.  We will use this in our CPR Formula below.

Use the following formula to determine how many shares to trade:

P = C / R

(P) Position sizing = (C) total Cash at risk / (R) Risk

In tomorrow’s article I’ll plug in a few examples to show you how to specifically use it in your own trading to help exponentially grow your trading accounts.

I discussed Position Sizing and told you how very important to trading success it is.  I also discussed the CPR Formula…let’s summarize below:

The CPR Formula Determines How Many Shares to Trade:

P = C / R

(P) Position sizing = (C) total Cash at risk / (R) Risk

I also created a spreadsheet that helps me figure this out quickly, take a look below.

Now read the example trade below then refer back to the spreadsheet above and see how much easier it is to figure this out with a simple spreadsheet. 

Position Sizing Model Example (P = C / R):  TRV

Let’s say, for example…

You BUY The Travelers Companies, Inc. (TRV) in an equal amount of shares between the Mid to Lower Keltner Channel Band at 56.20, at the 38% Fibs LL to NH at 54.50, and again at the 50% Fibs LL to NH near the MAs at 52.80 with an Initial Stop Loss at 50.70 slightly below the 62% Fibs LL to NH (just below the MAs).  Your Average LONG Entry Price is 54.50.  

Your Risk is 3.80 points, R = $3.80.

Let’s say, for example, with a $50,000 account balance, you are willing to risk 2% of your account balance ($50,000 x .02 = $1000), or C = $1000.  

You BUY The Travelers Companies, Inc. (TRV) between the Mid to Lower Keltner Channel Band, at the 38% Fibs LL to NH, and again at the 50% Fibs LL to NH near the MAs with an Average Price of 54.50 and you place your Initial Stop Loss at 50.70 slightly below the 62% Fibs LL to NH (just below the MAs).  

Your Risk is 3.80 points, R = $3.80.  

IF P = $1000 / $3.80, THEN you can trade up to a total of 263 shares.

There you go, look how easy that is.  Remember, Position Sizing is perhaps one of the most important aspects of trading success, so be sure to read this over and over again until it becomes second nature in your trading.

Money management is the administrative side of your trading plan.  It addresses the question of how best to use the capital available to you in the most effective manner possible with the goal of MAXIMIZING your PROFITABILITY while at the same time PROTECTING your CAPITAL by MINIMIZING the RISK of ruin.

The True Essence of Money Management Is Managing Risk

Wise money management is the basis of any good trading methodology and is what ultimately will help distinguish a consistently successful trader from the trader that consistently loses.  Many traders have fallen to the wayside trying to make a lot of money on a single trade – trying to hit that ‘home run’ – when they would have been better off making small (singles and doubles), steady gains.  Once you start doing this (and thinking this way), you will see your account consistently starting to grow.

Money Management includes consideration of the following factors:

  • Deciding on the OPTIMUM amount of money to commit to any one trade relative to your total available trading capital.
  • PROTECTING your PROFITS from erosion.
  • Avoiding (at all costs) turning a small losing trade into a huge losing trade.
    • If you keep your losses small, your profits don’t have to be ‘home runs’ to earn a good living.
  • Knowing when and how to increase the size of your cash commitment when the odds are more in your favor (i.e. risk to reward is really tilted in your favor, etc.).
  • Recognizing the importance of taking some of your winnings off the table after a winning streak.

Always Know Your EXIT Before You Enter…

One of the cardinal rules of good trading is ALWAYS to have an EXIT point before you even enter a trade.

  • If you know your initial risk, you can express all your results in terms of your initial risk.

Adjust Your Risk Management Strategy for Different Markets

While a sound trading methodology will produce consistency in any market, a trader must consider the volatility of each market he/she is looking to trade so as to size his/her positions accordingly based on his/her individual risk tolerance and trading capital.  Trading is trading, whether one is trading AAPL (trading at $194 with an Average Daily Range of $12) or BAC (trading at $31 with an Average Daily Range of $2), or even trading the E-Mini Futures or the FOREX market; it’s all basically the same.  However, there are some differences, such as margin, leverage, times of day the markets are open, limit locks, and volatility.  While each market does have its own “personality,” if you can trade one, you can trade the other.  A determining factor in which market to trade is based primarily on your individual risk tolerance and trading capital.

If the volatility of a market is a determining factor in position sizing accordingly, how does a trader define the volatility of a market?

What is Volatility?

Most traders refer to volatility as the size of change in the value of a market or the amount of uncertainty or risk in a market.

  • higher volatile market’s (i.e. stock’s) price changes dramatically in one day or over a few days of trading activity.
  • lower volatile market’s (i.e stock’s) price does not fluctuate dramatically over a short period of time, but changes at a steady pace.

It is easy enough to look at the values on the right of a chart and determine whether or not you are looking at a volatile or a non-volatile market, however…

How does a Trader define Volatility?

RANGE is directly proportional to Volatility.  RANGE is defined as the change of value in price per increment of time, or simply the difference between a stock’s HIGH price and LOW price for a particular time frame.

The Average True Range (ATR) is an indicator available in most charting software that measures volatility by defining the Average Range of price bars/candlesticks along with capturing volatility from an overnight gap up or down.

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The 15% rule is one of the easiest and best pieces of advice I have ever seen for defense. As you have said and I continue to see happen, it is amazing how the rule works out at exactly the time frame an amount we need almost every time. Thanks!   Steven K., CO

Have a great day and stay tuned for tomorrow’s lesson and be sure to give me your feedback, I would love to hear from you.

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