The two most important words in share trading are ‘how much’.
No, it isn’t how much you might make. And it’s not how much you could lose. Sure, these are important inputs, but they are not at the top of the list.
There is one factor that sits above these. It’s the single most important decision every trader must make. Getting this right is vital to your success.
Do you know what it is?
Okay, let me tell you…
I’m talking about how much to buy. Nothing else has such a big influence on your performance. It’s the swing factor that can make or break a career.
Today I’m going to tell you about three trade sizing strategies. I want you think about your own approach. You may find there’s a better way of deciding ‘how much’.
But let’s begin with a short story. I’m going to take you behind the scenes of an investment bank’s trading desk. It may surprise you how many professional traders go about setting their position size.
The trading desk
My first trade with a bank’s money was in 1992. I remember the lead-up vividly. I’d found a set-up in the interest rate futures market. There was just one problem — I didn’t know how much to buy.
You see, during all my training, no one had mentioned trading size. It was as if everyone just knew how much to trade. I asked my boss. He simply said to start by risking a few thousand dollars.
So that’s what I did. I knew my entry point and stop loss. I was then able to calculate how many futures contracts to buy. Easy I thought…there was nothing to it.
But it was far from perfect. My calculation was based on a ‘few thousand’ dollars of risk. It didn’t relate to a particular capital base. It was an arbitrary figure.
I started to pay close attention to other traders in my area. These were some of the best traders in the country. And many of them were also using a subjective approach to position sizing.
Trade size largely came down to a trader’s conviction. They would buy a more if a trade looked really good, and less if it wasn’t a standout. ‘How much’ seemed more of an art than a science.
Experience is an excellent teacher…you just need plenty of time. It took me five years to understand the flaws in this approach.
A big issue with subjective position sizing is consistency. Your performance relies heavily on getting the bigger trades right. It only takes a few larger losses to ruin an otherwise good year.
Then there’s the question of growth.
Traders naturally want to make larger profits over time. But bigger profits require larger positions. Knowing when to increase trade size, and by how much, is a challenge for the subjective approach.
So what’s the solution?
Well, let me tell you about two options. Both will give your trading consistency.
The first strategy is to use a fixed trade size — for example, $1,000 per trade. This is the same approach Quant Trader uses.
I like the simplicity of this method. It doesn’t rely on a set of calculations. All you need to do is decide on a standard trade value. This will largely depend on the size of your account.
Generally, I would aim for a portfolio of at least 20 stocks. This means someone with $20,000 might trade in $1,000 parcels. Brokerage will make smaller trades less practical.
A person with $100,000 has more flexibility. They may choose to hold 100 stocks with $1,000 in each. Another option is to trade fewer stocks, but increase trade size. There are many combinations.
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A fixed trade size ensures each stock has an equal weighting. This creates an even spread of risk. It also ensures you don’t have too little capital in your best trades, or too much in your worst.
So let’s have a look at how this strategy performs…
This test starts with a hypothetical $100,000 of capital. It then places an even amount on each trade — in this case, $1000. There is no allowance for costs and dividends.
I’ve run the test over the last 20 years. It’s uses the same algorithms as Quant Trader. The only difference is it only trades signal 1s. This portfolio has a cap of 100 stocks.
The fixed dollar method performs well. You can see a steady increase in the account size. The 250% gain is considerably better than the All Ordinaries.
But there’s a weakness in this approach. It doesn’t have a built-in strategy to increasing trade size. This can make a big difference over time.
The ‘percentage of capital’ strategy
Okay, let me tell you about another method. This how many professionals determine trade size. It’s also the strategy I use myself.
The previous approach used a fixed dollar value. This next method has one important difference…it uses a fixed percentage of capital. Let me explain what I mean…
Suppose you have $100,000. Under the fixed dollar method, you might use $1,000 per trade. This figure remains constant into the future. There is no mechanism to increase its value.
Now, say you use 1% of your capital instead. Your initial trade size would still be $1,000. But here’s the key point. As your capital changes, so too does the trade size — it dynamically adjusts.
The best way to demonstrate this is with an example. Let’s imagine your portfolio value increases by 10% to $110,000. Your trade size automatically rises to $1,100 — that’s 1% of $110,000.
This process continues indefinitely. Your trade sizes automatically adjust to match your capital. Importantly, your capital and trade size are always in proportion.
There’s another advantage to this strategy. It scales back your trade size when you’re losing. If your account drops by 10%, there’ll be a corresponding drop in trade size. This helps reduce volatility.
So let’s see the difference this approach can make…
The curve has the same basic shape as the fixed trade size chart. And it should — the only difference is the position sizing algorithm.
But have a close look at the slope of the two curves. You’ll notice the percentage of capital strategy rises at a steeper angle. This has a dramatic impact on profitability.
I have one more chart for you. I’m going to put the two performance curves on the same graph. You’re about to see why the words ‘how much’ are so important.
Okay, you ready? Let’s go…
The difference is massive. This isn’t due to stock selection — the tests use the same algorithms. It all comes down to position sizing. One strategy adapts to changing capital…the other is static.
The divergence of the lines doesn’t happen instantly. It takes about six years for it to become noticeable. This is because the initial increase in trade size is only small.
Look how much the gap widens. This is the magic of compounding — your profits go on to generate more profits. You don’t get this powerful tailwind with a fixed position size.
Don’t worry if you’re not ready for a percentage based approach. It probably won’t make much difference in the near term. It’s quite okay to stick to a fixed trade size.
Also notice my calculation for trade size is 1% of $100,000. This won’t work if your capital base is $20,000. Your trade size would be an unworkable $200. In this case, you may decide to allocate 5% of capital per trade — this comes to $1,000. You can always make adjustments over time.
Position sizing is a science, not an art. It took me years of trial and error to figure this out. You now have the formula. I hope it transforms your trading.
Until next week,
Editor, Quant Trader
Editor’s note: If you don’t know which stocks to buy, then Quant Trader can help. The system’s algorithms are constantly scanning the market for opportunities. It will then issue a buy signal, and calculate a unique exit stop.
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