But Position Sizing decides the magnitude of that fate (profit or loss). Hence, position sizing is equally essential as compared to entry and exit of the trade.
Hence, financial analysts prioritize position sizing when they plan to buy some shares in any security.
What Is Position Sizing?
Position sizing refers to the size of a trading position within a particular portfolio.
It can also be defined as a number of shares (or lots) per trade or the amount that a trader will invest per trade.
The famous trader Van Tharp defines this as 'How big should I make my position for any trade?'
Why Is Position Sizing Important in Trading?
Without proper position sizing, it is impossible to prevent a drawdown with a substantial amount of your capital on a single trade.
Hence, this is a must for all traders who want to avoid significant drawdowns in their accounts.
For the moment, assume you have Rs. 1,00,000 as trading capital.
You feel very confident on a script ABC, CMP at 100, and you think the price will go higher in the next few days. As a result, you buy 750 shares of XYZ.
The next day, you hear that a few popular products this company makes have been banned in the US and some other countries, causing the price to open at 22% below your entry price.
Due to this unforeseen incident, you decide to exit the trade.
You sell all your 750 shares at Rs. 78, and your trading capital reduces to Rs. 58,500, which is a 41.5% drawdown on your capital in a single trade.
How to Calculate Position Sizing
To know your position sizing, you should always know how much you ready to lose per trade if something goes wrong.
A rule of thumb in the stock market world is that one should not risk more than 2% of his portfolio per trade.
For example, if you have Rs. 10,00,000 as trading capital, then you should risk only Rs. 20,000 per trade.
Position Sizing Formula
Position Sizing = Risk Amount Per Trade / (Entry price – Stop Loss price)
We will look at an example to understand this concept.
If you look at the above CEAT Ltd chart, an entry can be taken at 1230 because of the trend line breakout, and we can keep SL at 1160 because if the price comes back to 1160, then it indicates that the breakout has failed.
We can aim the target at the peak, which comes at 1423.
Position Sizing = Risk Amount per trade / (Entry price – Stop Loss price)
If you have Rs. 10,00,000 of capital, your risk amount per trade is Rs. 20,000 (2% of portfolio).
Then Position Sizing = Rs. 20,000 / (1230 – 1160) = 285
Hence Position Sizing = 285 shares.
So one can buy 285 shares of CEAT Ltd if they have Rs. 10,00,000 as trading capital. Similar calculations can be applied to other trades as well.
Risk-Reward for the trade is highlighted using 'Red' and 'Green' zones on the chart.
Position Sizing Calculator
If you need a position sizing calculator online, use the below link
Along with the buying and selling levels in a trade, position sizing plays a vital role in trading.
Don't forget the below quote from the famous trader Larry Hite.
"I have two basic rules about winning in trading as well as in life - 1) If you don't bet you can't win 2) If you lose all your chips, you can't bet."