Position sizing is an important concept to understand when trading with a long-term goal. However, the mere term “position sizing” can sound overwhelming and complicated. It’s why we likely get so many questions regarding advice on determining the correct position size for beginners.
When starting out as a beginner trader, it’s best to start with small position sizes and slowly increase them over time until they find what works best for your trading personality and goals. Generally speaking, if you are not sure about how much of your portfolio should be in one trade or investment, it is always safer to have less than more at stake.
The only way you can know what size is right for your own investing and personal finance situation is by trial and error, but hopefully this article gives you some helpful tips and ideas that work well for most beginners.
Want to skip the tips and start investing in yourself right now? Download the Wealth Stack app for free to get started today.
What is Position Sizing in Investment?
Position sizing, put in the simplest way possible, is the dollar amount that an investor can feasibly trade without risking all of their investment capital. You can use position sizing to help determine how many units of a security you can “safely” purchase, which helps control risk and maximize your returns.
Experienced investors (and now you) use position sizing to help determine how many units of security they can purchase, which helps them to control risk and maximize returns. And, the good news is that position size isn’t something arbitrary like the value of a certain stock can be sometimes (note: we said stock, not the business itself). Nope. Position size is determined by a simple mathematical formula which helps control risk and maximize returns on the risk taken.
Now, you may ask yourself, “How do I know my position size?”
Below you’ll find three steps we suggest taking to determine proper position sizing as a beginner investor. These steps work for any market, making the formula easy to follow and apply.
1. Calculate the Account Risk
By account risk, we’re referring to the risk you’d be assuming for your entire account depending on the amount you plan on trading. Determining the appropriate position sizing requires that you define this risk.
As a general rule of thumb, you shouldn’t risk more than 1-2% of your investment capital on any one trade. This is true regardless of the size of your account. So, for example, if your account is $1,000, don’t risk more than $10 on any one trade.
Note: Professional fund managers usually risk less than 2%, so keep this in mind.
What’s the deal with 1%? Sounds like so little, right? Yeah, it is, but it’s the best way to avoid losing it all on one massive trade. In short, it’s part of learning to invest wisely and focusing on long-term goals instead of short-term gains.
By only investing 1-2% on any given trade, this means that you can suffer a string of difficult losses and not be totally wiped. And, by risking 1% of your total investment capital on one trade, you’re still able to see large returns as long as you invest wisely (download Wealth Stack for help with that).
2. Calculate the Trade Risk
Now that you’ve calculated the account risk, it’s time to think about the trade risk. In order to do this, you’ll have to figure out where to place the stop-loss order. Wait a second, let’s rewind. What’s a stop-loss order?
A stop-loss order is an order you’ll place with your broker so that they buy or sell a security when it reaches a certain price. These orders are designed to help limit your potential losses on a position in a security in that you’re waiting until the price is where you want it.
Now, how do you determine when the price is right? That’s part of calculating the trade risk. In this context, the trade risk is the difference between the intended entry price and the stop-loss price.
So, let’s say that you want to invest in Tesla. You intend to purchase it when it goes down to $708 and you place the stop-loss order at $700. The trade risk is $8 per share in this case, which is the “cents at risk,” essentially.
This requires you to really think about your entry point and your stop-loss point. How much do you want to purchase the stock for and how much would it have to drop before you’re ready to sell? Once you know how far away from your purchase price your stop-loss will be, then you can calculate your ideal position size for that trade.
3. Determine the Proper Position Size
Whew, now you’re ready to make the calculation! You’ll use the account risk and the trade risk to determine the proper position size.
Essentially, now you know how much you can risk per trade (account risk) and how much you can risk per share (trade risk). Take those two numbers and use this calculation:
Account Risk / Trade Risk = Proper Position Sizing
So, let’s use the example above. Say your total investment capital is $20,000. You’re following the 1% rule which means that you shouldn’t risk more than $200 (1% of the total) on this one trade. Also using the Tesla example above, this means that your trade isk is $8 per share.
This means that you can purchase 25 shares of the stock.
Start Investing in Yourself
Learning how to determine proper position sizing is just one small part of learning how to transition from a beginner investor to a pro. As well, there are other position sizing strategies you can implement depending on what you’re trading and the total amount of money you have to invest with.
To learn more about your options and to learn more about how to invest like a pro, download the Wealth Stack app for free. There, you can learn from free, fun video courses that will teach you how to build a solid financial foundation in the pursuit of long-term wealth.