Marc Nicolas

Master Position Sizing and Capital Allocation in 4 Easy Steps

By Marc Nicolas, DayTradingZones.com

In my 17 years of trading and having traded for a hedge fund, it is Proper Position Sizing and Capital Allocation which has kept me consistently in the game as a professional trader.

Even if you have a great trading strategy, if you do not understand how to properly size your positions, you are unlikely to achieve a comfortable level of consistency and you risk blowing account after account. Proper Position Sizing and Capital allocation protects your risk capital by determining how big a position you should take on any one trade. This will mean fighting the urge to buy an arbitrary number of shares because you “feel” a trade is a sure winner.

It is the bridge between your chart analysis and risk management plan. Unfortunately position size is the most overlooked aspect of trading and yet is the most important aspect, especially with the volatility we have seen in the markets lately.

I hope the 4 steps below will help you:

• Step 1: Capital Allocation

This calculation will split your capital according to the number of different positions or instruments, like futures, stocks, forex, commodities or options you want to trade, or hold in your portfolio. For instance, assume that you have $100,000 Total Risk Capital and you want to include 5 different positions in your portfolio to diversify your risk. Your Instrument Capital Split should be Total Risk Capital/Number of Positions, in this example, $100,000/5 = $20,000 is the capital allocated to each position.
Usually what traders do now is incorrectly take the $20,000 Capital Allocated and divide it by the price of the stock and buy that number of shares. For instance if XYZ Company is trading at $27.50, $20,000/$27.50 is 727 shares. This is a mistake because it does not take into account your Stoploss or Capital Risk %. For instance if you did this for each of the 5 positions you would be risking a maximum size and not taking into account stoploss or Capital Risk %. Step 2 illustrates how to incorporate your Capital Risk %.

• Step 2: Maximum $ Risk Per Trade

You should only ever risk a certain percentage of your Total Risk Capital on any one trade/position. Since 2001 we have been suggesting 1% or less, especially in the beginning. 1% because it allows you 100 consecutive losing trades before you blow your account so you have plenty of time to maneuver and you don’t become emotionally attached to any single trade or position.

So for each instrument your Maximum $ Risk Per Trade is 1% x Capital Allocation, in this example, 1% x $20,000 = $200 is the maximum amount you should risk on each allocated position. Next, before calculating the optimum shares to hold, in addition to the 1% rule, you should incorporate the last factor, a Stoploss Level.

• Step 3: Stop Loss Level

This step is critical.

You must base your Stoploss on your charts and personal trading process, not an arbitrary monetary level.

So assume that your chart technical analysis and trading strategy is showing you a long signal for XYZ Company, which is trading at $27.50 and that signal will no longer be valid if price goes below $26.10 support zone, so you decide to set your stoploss at $26.00, risking $1.50 per share. Now you know you are prepared to risk $1.50 per share, and you have your 1% risk of $200 from step 2, you can calculate the optimum number of shares to buy for the allocated position using the formula in step 4.

• Step 4: Optimum Number of Shares 

To calculate the maximum optimum number of shares to buy you take the formula:

Maximum $ Risk Per Trade/Stoploss Level = Maximum Optimum Position Size.

In this example, $200/$1.5 = 133 shares. This is a much safer number of shares than the 727 shares at risk from step 1. This is how the hedge funds and pro traders correctly position size and even if you have a personal trading strategy which is not optimal these position size principles will keep you safer, and this is very profound – even with a bad trading strategy, the mathematics of proper size position will keep you in the game longer than if you have a great process but apply it with poor money management, stop loss and optimum position size principles.

Also because you know you are only risking a small percentage of your capital (1% or less) on each position your trading will become less stressful and be based on your charts and trading process, not your emotions, consequently you have a much better chance of achieving consistency and staying in the game for the long-term.

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Marc Nicolas

Marc is a 17 year trading veteran who cut his teeth as a proprietary trader for JP Capital a division of Andover Trading, and since 2002 has been offering Emini, forex and option trading Private Mentorships made in real time.

DayTradingZones.com was born out of simplifying Marc's own trading, so instead of watching a multitude of screens, charts, indicators, the idea was to group everything into one chart per symbol to make faster, easier decisions with a simple visual tool, answering the key fundamental trading questions, where are the major supports and resistances, what is the larger trend, what is the immediate trend, where to enter, place a stop loss and where to exit.