Position sizing 101, 2nd edition

I’ve been getting a lot of questions around position sizing, so I’m reposting this article I wrote over a year ago, and providing some additional context around the percentage of capital one should risk in a trade and how to size up and down based on conviction.

Long Term Capital Management. The Great Financial Crisis. Three Arrows Capital. FTX. Silicon Valley Bank. All cautionary tales of market disasters fueled by a lethal mix of over-leverage, excessive position sizing, and a misunderstanding of risk. But do we ever learn from our mistakes? Clearly not.

Knowing how to properly size positions makes the difference between profitable and losing traders. Even for those in the upper echelons of trading and portfolio management, position sizing separates the good from the great. In this post, I will cover the basics of position sizing, starting from individual trades to overall portfolio construction.

The basics of constructing a trade. Your first move should be to pinpoint the market level that invalidates your trade idea if reached - this is where you’ll set your stop. Make sure your stop is tucked behind a solid technical support or resistance that isn’t too close to the market, providing a robust line of defense. Once you've established the distance between your entry point and your stop, you can calculate your position size, guided by the percentage of trading capital you're willing to wager on an idea. This distance to the stop is also the denominator for your reward-to-risk ratio, a crucial factor in determining the attractiveness of a trade idea.

The idea that a trader should identify the stop loss level before doing anything else should be elementary, but I can’t tell you how many times I see traders neglect this basic concept. Heck, I’m sometimes guilty of it as well. The distance from your entry to your stop dictates every aspect of your trade, which is why it's so important to get this right from the very beginning.

Determine what percentage of your capital you want to risk on this trade. A rule of thumb is to set your default position size so that you don’t hit your drawdown limit even if you stop out ten times in a row. Imagine trading was a video game and what you risk on a trade is one life. You should size your positions so that you can lose at least ten lives in a row without it being game over.

But what does game over mean for different types of traders? For hedge fund managers, it might mean losing their job if they hit their max drawdown in percentage terms. For bank and prop traders, it could be hitting their annual drawdown limit in dollar terms. And if you're a well-capitalized independent trader who sets your own drawdown limits, you should aim to keep it under 20% (requiring a 25% recovery to break even). Anything more, and the road to recovery becomes insurmountable - if you draw down 40%, you need to make a whopping 66% just to break even.

Another determining factor is how many positions you tend to have open at any given moment. A trader who often runs 7-10 positions at any given moment should be risking less than half on each trade than a trader who runs only 1-3 positions at a time.

Newer traders with small accounts can consider taking slightly larger risk, especially if they have extra capital on the sidelines that can replenish the account in the event of a drawdown. However, there should still be limits. When I started out, I was risking stupid amounts - 5 to 10% of my trading account - on a single idea. My pnl swings were huge - from $50k to $400k, and back down to $100k. From $100k to $1m, then back down to $500k. The size of my positions and pnl swings were too large, and I would have been better off if I had tried to achieve a smoother equity curve. I realized that the size of my risk would result in me blowing up all my capital at some point, so I started reducing how much I risked on each trade over time.

Today I have a standard size of risking 1% of my capital on each trade. I’ve arrived at this number after years of trial and error and knowing what works for me. It’s a function of my win rate (45%), the number of positions I usually have open at any given time (5-8), and the drawdown threshold I try to avoid (20%).

Conviction - that elusive quality that sets successful traders apart from the rest. In my experience, my biggest losses have come from my moments of highest conviction. I either sized those positions too large, or let the market go too far against me before stopping out. High conviction comes hand-in-hand with heightened emotions, which can be detrimental to optimal decision-making. These days, if I feel good about a view or a position, I wait for it to go in my favor before layering on more risk while tightening my stops.

Journaling is one way to measure whether conviction levels are actionable and profitable. By keeping track of past trades and analyzing their outcomes, you can get a sense of how effective your convictions have been in the past. Are you consistently profitable when you go big on a trade, or do you tend to do better when you play it safe? Answering these questions can help you size your positions more effectively and ultimately boost your bottom line.

When to reduce position size: As a former head of a bank trading desk, I've seen it all - from traders desperate to recover from a devastating loss to those stubbornly clinging to an outdated macro view that is getting them stopped out over and over again. The natural human inclination was to trade more and trade bigger to make it back. The path to recovery was always the opposite: reduce your position sizes to minimize the monetary and emotional stakes of trading, bringing you back to your center. It is a one-size-fits-all solution traders can resort to in times of adversity.

Knowing this, I have a rule that dictates that I reduce my position sizes by one-third if I am down more than 5% from my high-water mark and reduce position sizes by another third at a 10% drawdown. Each drawdown threshold also triggers a reassessment of what open positions I want to keep open, and tightening the stops on the ones I keep. Not only does this rule help me regain my center, but it also helps me ride out difficult trading environments, which often occur during times of macro regime change. The key to this game is survival - if you survive as a trader, year after year, the gains will come at some point.

How to increase your risk: Congratulations! You've had a good run and now you've been handed more AUM or bigger risk limits. But hold on, it's not just as easy as changing the numbers on your orders. Many traders falter at this critical juncture, and their performance suffers as a result. It's like hitting a psychological ceiling that they just can't break through. The increased risk and pnl volatility throws them off their center, resulting in poor performance right off the bat.

There are two helpful tools for dealing with this mental roadblock. First, get into the habit of converting your pnl into percentage terms in your head. Having a uniform way to assess your performance, regardless of whether you’re trading $100k or $100m, will come into handy whenever it’s time to size up or down.

Second, ramp up your risk gradually. Resist the temptation to go all-in right away. Increase your position size by 10% at a time and see how it feels. Take your time to get comfortable with the added risk before going all-in. It may take longer, but it's worth it to avoid a potential disaster.

Portfolio construction: Traders should also be aware of correlation between their positions. If you are both long Treasury futures and short usd/jpy, a stronger than expected non-farm payrolls number could stop both positions out. There is nothing wrong with having multiple correlated positions if you have a high-conviction view, but your eyes should be open to the fact you are risking more lives if a market event pushes all of your positions against you in one fell swoop. Sizing down each position in a basket of correlated trades is one solution to this problem.

The ideal global macro trader has an edge in multiple non-correlated markets and strategies, as well as an ability to profit in multiple time frames. Portfolio diversification plus time horizon diversification can help traders deliver superior returns with less volatility, provided that he has a profitable edge in all the markets and time horizons he is trading in.

In the end, proper position sizing is not just about managing risk, but also about maximizing returns. By following the basics of position sizing, traders can minimize their losses, increase their chances of success, and avoid becoming another cautionary tale.