Reader Question: After reading (in 3 days) “Trade Your Way to Financial Freedom” I am stumped by a seeming contradiction. After analyzing personal account trades over the past 6 months, it seems clear I need to be much, much bigger in my trades. However, the trades are already 10% positions in my IRA. When I calculate the position size suggested by your formula in the book, my position sizes should be 25%….yet throughout the book, I am reminded to keep position sizes at 1% of equity. The book was extremely useful but I continue to scratch my head about this topic. Regards, J.L.
A: You are mixing up position size and initial risk. The 1% you are referring to is the initial risk amount. That’s the amount of money you are willing to risk or lose on a trade often expressed in terms of percent of equity. Position sizing is the total dollar amount of a trade or total shares, which is also often stated as a percent of equity. Additionally, your risk amount or 1R should generally not exceed 1% of your equity and any single position size should generally not exceed 20% of your equity.
Use the CPR Method written about in the book and calculate your risk first to determine your position size for a trade. If you had a $100,000 account and were willing to lose $1,000 on a trade, you would risk 1% of your equity. $1,000 is your 1R. Say you liked a stock at $10 with an $8 stop price. You would buy 500 shares ($1,000/$2 per share risk = 500 shares). In this case your position size would be $5,000 which in equity terms is a 5% position. Now say you wanted to buy another stock at $10 because you believe it just hit a major bottom at $9.80. You set your stop price for the trade at $9.75 and you would calculate a 4,000 share position ($1,000/$.25=4,000 shares). This $40,000 position is 40% of your equity. Even though your 1R is at an acceptable 1% of equity, this big of a position exposes an unacceptable share of your equity to market risk or price shocks. Imagine if you had taken on a position this big on the afternoon of Monday, September 10, 2001 or on the eve of some other market moving event. With that much equity exposed in the market in a single position, you could take a hit from which it would be hard to recover. You need to manage both the initial risk amount and the position size.
In your IRA account, it sounds like you have a real life example closer to the second scenario mentioned above where the optimum position size for trades might be larger than your equity allows. This can and does happen— even in leveraged accounts. There are several things you can do about this situation, but the best alternatives really depend on your objectives.
