HOW MUCH?
Position Sizing is the basic question of how much do I buy or short.
It is also known as Money Management or Risk Management.
This critical part of trading, together with stops, helps control the risk to your capital.
The correct use of Position Sizing helps reduce the risk of ruin or risking too much and losing your capital or so much that you quit your system.
Position Sizing sets up how much you risk per trade or in other words, your set loss tolerance if the trade gets stopped out.
Using that distance from the entry price to the stop, plus the percentage of your capital you risk per trade, you can calculate the size of your position.
Using an easy example, you go long on a $10 stock and your stop is set at $8.
You only want to risk 1% of your $10,000 capital on this trade.
The calculation is 1% x $10,000 for a risked amount of $100.
If the trade hits your stop, you have $2 per share movement at risk.
Your position size can then be calculated by taking your $100 risked amount divided by the $2 per share movement risk.
$100 / $2 = a position size of 50 shares.
To summarize this example, you purchase 50 shares and if you are stopped out, you only lose $100 or 1% of your capital.
Your loss is limited to a small amount and your account survives to keep trading.
NORMALIZING THE MARKETS
As you trade, you are trading on price alone and not concerned with the fundamentals that each market's price represents. You need a way to keep the same basic position size for each market in your portfolio selection. For example if you have a $10 stock or a $500 stock, you need a way to keep the risk of each position the same. Buying one share of each would have a greater risk for the $500 stock if they moved the same percentage. Even if you set a stop based on a percentage of movement for the $10 stock and $500 stock example, each may have different normal range of movement. If the $10 stock is volatile and has a daily range of $2 while the $500 stock is not volatile with $2 daily range and position size is based on a percentage, the risk will be higher for the $10 stock. You will need more than just a percentage of the price to keep your risk the same across each of your markets.
PERCENT VOLATILITY
Percent Volatility Position Sizing lets you keep the same risk percentage for each position. It helps you normalize your risk across your chosen markets that may vary significantly by price and volatility. A common way to accomplish this type of position sizing is to use the ATR 's moving average to account for the daily movement. For our $10 stock and $500 stock examples above, let's say the 14 day ATR is $2 for each. If our stop uses the single 14 day ATR of $2 for each and with a $10,000 account using 1% risk, we'll have a position size of 50 shares for each stock. This example uses the same calculation as above, $100 / $2 = 50 shares. Using the Percent Volatility Position Sizing keeps each position limited to 1% of the capital if the stops are hit. We can then trade price alone for each of our markets and keep our risk limited no matter what we are trading. Van Tharp discusses Position Sizing further in Trade Your Way to Financial Freedom.
The next page is about stops that help keep losses to a minimum and protect your downside. Your exit when the trade goes against you.