Position sizing refers to how large of a position that you take per trade. Some trades are so obvious that you can take a huge position or, as some call it, “load the boat”. These setups are shouting, “grab me by the face”. Some trading opportunities are attractive enough for a “large” position. In other trades, you just want to go for a taste and perhaps add more later. Learning when to have the most size is a skill that new traders must acquire. Poor position sizing leads to inconsistent results. In an upcoming chapter I will provide some thoughts on what I call the 2% rule: no matter how good of an opportunity, you may not risk more than 2% of your account in one trade. Live to trade another day.
New traders think they need to trade with huge size to make significant profits. There is plenty of money to be made trading with modest size, especially in actively traded medium float Stocks in Play. You can make considerable money trading in and out of an active stock with small size. Likewise, you can lose a great deal of money trading in and out of an active stock with too big of a size.
New traders often ask me how much size to take in a trade. This is not a good question. The correct question is whether you can handle the size you are taking, regardless of how much buying power you have. Institutions and proprietary trading firms have significantly larger and deeper pockets than individual retail traders like us because they negotiate with a clearing firm to gain intraday buying power. While retail traders like us can only receive a 4:1 margin, a trading firm with a successful track record can obtain almost unlimited intraday buying power. They can offer as much buying power as they want to any trader within their firm, but they don’t. They have strict risk control rules, and each trader has a limited buying power to start. They slowly increase the buying power of their traders as they improve. More experienced traders have access to a larger buying power, and their profit offsets the losses of new and less experienced traders, to make their collective risk minimal.
Although I take a large position at times when the risk/reward is in my favor, I know I need to be able to handle the risk. When I take a large size and get a bad hit, I am able to recover. A bad loss right at the Open does not paralyze me. I am able to reassess my trading situation and continue trading.
Position sizing essentially depends on the type of stock you are trading. Medium float stocks make smaller moves in price and are therefore easier to manage the risk in during a trade. In contrast, for low float stocks that can move 10% or 20% in a matter of seconds, I never take a large position, even though their price is typically low (in the range of $1 to $10) and I have sufficient buying power for a very large position.
I suggest traders start with only 100 shares. One hundred shares is low risk, and although it’s a low reward, you need to start somewhere. When you are more confident in managing your emotions, you can increase the share size slowly. Develop your trading skills, build your trading account, and slowly increase your size.
My trade size depends on the price of the stock as well as my account size and risk management rules (Chapter 7), but 2,000 shares is my recent usual share size if I am trading in the $20 to $50 price range.
For a more expensive price range ($50 to $100), I reduce my total share size down to 1,000 shares. I rarely trade stocks higher than $100. The more expensive stocks are less attractive to us retail traders and are often dominated by computers and institutional traders.
As explained earlier, some experienced traders never enter the trade all at once. They scale into the trade, meaning that they buy at various points. Their initial share size might be relatively small, but traders will add to their position as the price action validates their idea. They might start with 100 shares and then add to their position in various steps. For example, for a 1,000-share trade, they enter either 500/500 or 100/200/700 shares. If done correctly, this is an excellent method of risk and trade management. However, managing your position in this system is extremely difficult and of course requires a low-commission brokerage firm. Many new traders who try to do this will end up overtrading and will lose their money in commissions, slippage and the averaging down of the losing trades.
I rarely scale down into a losing trade. If I want to enter into the position in various steps, I try to scale up; I add to my winning position. Remember, scaling into a trade is a double-edged sword and beginners may use it incorrectly as a way to average down their losing positions, sending good money after bad. I don’t recommend scaling as a method for beginners. Although they can appear similar, there is a huge difference between scaling into a trade and averaging down a losing position. Averaging down losing positions is perhaps the most common mistake a beginner will make and that will almost certainly lead to the end of their short trading career.
What is averaging down?
Imagine you buy 1,000 shares of a company above an important intraday support level at $10 in the anticipation of selling them at the next level of around $12. Instead, the stock breaks the support level and drops to $8. You have lost the trade and you should have been stopped out. Since your original trade idea was to go long above the support level, and now that that level broke, you have no reason to be in that trade. But, if instead you buy another 1,000 shares at $8, you now have 2,000 shares with an average cost of $9. It is unlikely the price will hit your $12 target, but it is likely that the price will rally back to $9. At $9, you can sell all of your 2,000 shares at break-even and extricate yourself from this losing trade with no loss. Even better, if their price goes to $9.50, you can close your 2,000 shares with a $1,000 profit. That sounds very tempting, but it is wishful thinking.
For a beginner, averaging down a losing trade is a recipe for wiping out one’s account. Remember, averaging down does not work for day traders. I have tried it. About 85% of the time you will profit when you average down. But the 15% of the time when you are wrong will blow up your account. The losses during these 15% of trades will far outweigh your gains from the 85%. Just forget about it. It is a waste of your mental energy. Remember, it only takes ONE bad trade to blow up your account and for you to be done with your day trading career forever.