Most trading and investment books give the same suggestion to traders and investors:
Keep your position sizes small so that you won’t blow up your portfolio even if you lose a lot of money on one trade.
This usually translates into “keep your position sizes below 5%” or “don’t risk more than 2% on any trade”.
This one-size-fits all approach to position and risk management is only suitable for beginners who have no idea what they’re doing. Yes, beginners should keep their position sizes small because they will probably lose a lot of money on their first few trades. But this isn’t a website for complete beginners. How intermediate and advanced traders determine their position sizes depends on a few factors.
*This is not a post about whether you should scale-in or go all-in. It’s about what your MAXIMUM position size should be on a single trade or investment.
How knowledgable you are about your market
Some traders use a standard set of technical analysis tools (e.g. momentum indicators, support/resistance trendlines, chart patterns) to trade multiple markets at the same time. Other traders such as myself focus on one or two markets.
Traders who trade multiple markets will naturally have a poorer understanding of an individual market than traders who focus on one market. E.g. if I spend 100% of my time trading the S&P 500, my understanding of the S&P will be better than someone who splits his time between trading 5 different markets (stock market, bond market, gold, oil, and cryptocurrencies). Focus is the key to greatness.
*Technical analysis is not a holy grail. Fundamentals are important too. People who say “price is everything” are either too lazy to learn about fundamentals or just don’t know where to start. A person with 2 eyes is always better off than a person with 1 eye.
You will naturally be less knowledgable about any single market if you trade multiple markets. Hence, every single position should be smaller because the odds of a loss are greater.
You will naturally be more knowledgable about your market if you only trade a single market. Hence, every single position should be bigger because the odds of a loss are smaller.
For example, I trade the U.S. stock market almost exclusively. Hence, I either go 100% long UPRO or 100% cash in my medium-long term portfolio. I don’t use small position sizes.
Different assets have different levels of volatility. For example, the stock market is less volatile than gold and silver. The more volatile an asset, the greater the probability of a large loss. The less volatile an asset, the lower the probability of a large loss.
- Your position size should be smaller if you trade a more volatile asset.
- Your position size should be bigger if you trade a less volatile asset.
Conviction about your market outlook
Most of the time the market isn’t 100% bullish or 100% bearish. The market is usually somewhere in between. Your position size should adjust based on the level of conviction you have for your market outlook.
E.g. let’s assume you’re bullish on the stock market.
- You might only want to go 50% long stocks if you’re some-what bullish.
- You might want to go 80-90% long stocks if you’re extremely bullish.
The market stage
Every trader needs to understand:
- Is the market that I’m trading in a bull market or bear market?
- Where is the market in this bull/bear? Is this the first quarter of the bull/bear market? Is this the last quarter of the bull/bear market?
Risk is heightened in the final quarter of a bull or bear market. Perhaps your timing is off. Perhaps the bull/bear market reverses a little earlier than you anticipated.
That’s why it’s best to shrink your position size in the final quarter of a bull or bear market. E.g.
- It’s the final quarter of a bull market and you’re long stocks. You might want to be 75% long stocks instead of 100% long.
- It’s the final quarter of a bear market and you’re short stocks. You might want to be 75% short stocks instead of 100% short.
The nature of your financial product
More and more traders are using leveraged ETFs to trade. Some leveraged ETFs like NUGT (gold miners 3x long) face a problem called “erosion”. Erosion basically means that the leveraged ETF (e.g. NUGT) will lose a lot of its value over a long period of time, even if its underlying market (e.g. GDX) is flat.
You must shrink your position size if you trade an ETF that faces significant erosion problems. You will lose a lot of money from erosion if your timing is off and your trade is too early. A massive position size + erosion is a recipe for large trading losses.
Understand the correlation between your positions
Some traders will keep their position sizes small by being long 20 different stocks. Then they will say “I diversified my portfolio!” I disagree.
This is essentially one big position (100% long stocks). Individual stocks are HIGHLY CORRELATED to each other.
- The vast majority of individual stocks will crash when the broad stock market crashes.
- The vast majority of individual stocks will rise when the broad stock market soars.
Traders should look at how many UNCORRELATED positions they have. A position size is “small” only if it is relatively uncorrelated with other positions. Don’t make this basica error when determining your position size.