Sunday, August 10, 2008

Thoughts on Position Sizing

Gio over at Hawaii Trader and IBankCoin asked me for some thoughts on position sizing from a swing trader's perspective. I never really put my strategy into words for this aspect of trading, and to be honest, I think a lot of times it is more of a "feel" thing for me, but then I thought more about it and realized it would probably be a good idea to do so. Here are some of the thoughts I came up with:

  • The potential loss I face when I start a position is probably the biggest factor for me in how big of a position to take. I chiefly use moving averages and support/resistance levels as my stop loss levels - not just flat percentage stop losses. If I get into a stock that has a clear stop loss level very close by(therefore making the potential percentage loss small), then I may take a larger position because my overall dollar loss will still not be that big (because the percentage loss is so small). However, if say I missed a breakout and was farther away from a logical stop loss level, I would not want to take as big of a position because now my potential percentage loss is bigger, and if I took a bigger position, I would be facing a bigger potential dollar loss as well. I like to cut my losses very quickly, probably quicker than most, so this may not work for everyone.
  • The overall market should play a big role in how big of a position you take as well. In a clear uptrend or downtrend, it is safer to take big positions in my opinion. In a choppy, whipsaw environment (like we have had recently) taking larger positions is a good recipe for disaster. Obviously, you need to have a system to determine what type of market you are trading in - there are various techniques for this. I use technical analysis of the indices for this and also a set of Telechart scans that I keep track of each day and use as an indicator of the market trend and to also show possible turning points in the market. For instance, right now my momentum indicator is at its highest numbers ever (or at least since I've been tracking it) and when this gets to extremes on the plus side, it usually signals a market that has run too far too fast and needs to cool down. Therefore, right now, based on that, I would not be taking large long positions right now because I feel it would be too risky.
  • Recent trading success also is a big factor in position sizing in my opinion. If you find yourself on a losing streak, or just kind of grinding your way sideways, that probably is a signal that the market is not setting up well for your particular trading style, and in that case, you should definitely reduce your position size. I know I have personally seen that this past month. Stocks that I thought looked like very good setups have not acted anything like I expected, and that action told me it is not a good time to make big bets. Things are too hard to do that right now. On the other hand, if you begin to put a string of very successful trades together, and setups that you see act well and do what you expect them to do, then perhaps start to take bigger positions. A lot of this is just psychology too - if you get some bad trades strung together, your instinct is to try and get the gains you lost back quickly. This is counterproductive however - unless you are trading a totally new strategy and not following your normal rules that you've had success with, most likely the losses that occurred were a result of difficult market conditions. And when you try to get those gains back quickly, all you are doing is forcing yourself to make more trades in a poor environment, which is certainly not a recipe for success. If you condition yourself to trade less and in smaller positions when you are having less success, you will do a better job of preserving capital during difficult times and slowly allow yourself to regain confidence without blowing out your account.
  • I would also add that fundamentals usually play a role for me in how big of a position to take. If I am looking at a nice chart of an IBD-quality stock, with great growth and sales growth, then I would be willing to take a larger position. The fundamentals doesn't guarantee the trade will work, but it gives it a better chance of working, as earnings acceleration are the biggest factor in stock price appreciation. On the other hand, if I am looking at a biotech that has negative EPS, I won't take a big chance in a stock like that. There are just too many question marks to take a large position. The chart setup is always the number one factor for me in trade selection, but fundamentals are important in my opinion as well.
  • Finally, I think it is important to remember to build positions slowly as a swing trader. Ideally, I rarely will take a full position in a stock during my first trade. Instead, I will start a position(usually around 50-75%) and automatically look for a point where I will want to add to it. If it doesn't follow-through and hit the add point, then no big deal - I get out of a small position with a small loss. But if it does move higher, I am forcing myself to add to a winning position, which is always a good thing. It makes the positions that are working automatically bigger while keeping losing positions small.
Hope this helps and is informative. Good luck next week.

Update: I realized I wanted to add a little about the amount of my account I dedicate to a particular stock.
  • Based on William O'Neil's recommendations in his wonderful books, I don't really believe in diversifying. I really try to be focused in my positions, rarely having more than five or so positions total. So I am willing to put up between 25-33% of my account into one stock. I usually start my positions around 15-20% of my account each. That may seem like a lot, but that is also why I cut my losses so quickly. I can concentrate my positions without too much harm to my account (usually) because I try to keep all losses around 3% or less. That equals out to about 0.5% of my account per loss, but I try to keep it lower than that actually. Most traders I read about usually use the 1% of account value as how much they risk on a trade. I prefer to risk or lose less than that. If trades don't work right away, I don't see any reason to hold onto a stock. Get rid of it and move onto a better one. You can always get back into a stock if you need to. I would rather be safe than sorry. And if I follow my buy and sell rules (getting rid of ones that don't work right away, adding to ones that do) it usually allows me to get bigger positions in stocks that are working well while not holding onto positions that stink.

As I gain more and more experience as a trader, perhaps my strategies will change, but for now, I feel this is the best way for me to trade, and it goes along with the general CANSLIM philosophy that I try to follow in my swing trading. This method isn't perfect - no method is in trading - but it works for me and for my personality and temperment.

1 comment:

Anonymous said...

Read this post over on Gio's new site - excellent post!

Thank You