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The Significance of Position SizingTue, Jan 28 2014, 16:01 GMT

by Nikos Akkizidis | Independent Analyst

The decision related to the optimal quantity to be acquired when initiating a position is one of the most important aspects of portfolio management. This can be attributed to the fact that position sizing directly affects diversification and money management. However it is often glossed over or handled improperly by most investors.

Diversification attempts to spread risk across many instruments, as well as increase the opportunity for profit by increasing probabilities for catching successful trades. Proper diversification requires making similar, if not identical, bets on many different instruments.

Money Management is really about controlling risk by not betting so much that you run out of money before successful trades come. However the majority of investors even if they have an otherwise valid trading strategy risk far too much on each position increasing their chances of going bust. In order to measure the size of an investment position there are two major steps:

- The first step is determined the money risk, relative to the total amount of investment capital. That risk determines the amount of money might be lost on an investment position.

Consider the following example;

The total investment capital for an investor reaches the level of $100,000.  The percentage risk on any position set at 2% of the total investment capital 

Thus the amount of money that could be lost on an investment position is calculated as follows:

$100.000 x 2% = $2,000

- The second step is to calculate the drawdown risk in each investment product which will also determine stop loss levels. We use this risk measurement to build positions in increments that represented a constant amount of risk.

Suppose that a price of a share listed in New York Stock Exchange is $80  Suppose then that it is calculated that the drawdown risk for this share is $1.6  Therefore if there is a decline in prices below $ 78.4, a stop loss order is activated.

The above steps are summarized as follows:

Total Investment capital: $100,000 Percentage Risk per Inv. Position: 2%  Amount of money could be lost per Inv. Position: $2,000 [$100.000*2% = $2,000] Price of a share: $80 Drawdown Risk per Share: $1.6 Stop Loss level: $78.5

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Akkizidis Nikolaos

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In order to calculate the position size, it is sufficient to divide the amount of money that corresponds to the amount of money could be loss per investment position, with the amount of money that corresponds to the drawdown risk per investment product.

Position size = ( Total Investment capital* Percentage Risk per Investment Position )/(Drawdown Risk per Share)

($100,000 * 2% )/$1.6= $2,000/$1.6 = 125 Shares

The same strategy is followed in order to calculate the number of contracts in derivatives markets:  

The maximum amount of products held is recommended not to be more than 4 products in one particular direction (i.e., 4 long or 4 short) if there is a strong correlation between them. That means the maximum loss of the entire portfolio shouldn’t be more than 8% for a single market. For markets that are closely correlated, there could be a maximum of 6 investment products in one particular direction (i.e., 6 long or 6 short). Closely correlated market groups include heating oil and crude oil; gold and silver; the currencies as a group; interest rate futures such as T-bills and eurodollars; and so on. For loosely correlated markets, there could be a maximum of 8 products in one particular direction (i.e., 8 long or 8 short). Loosely correlated markets included gold and copper; silver and copper; and many grain combinations. 

www.FXStreet.com The Significance of Position Sizing

Akkizidis Nikolaos

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This model ensures that different trades in different markets tended to have the same chance for a particular loss or a particular gain and increased the effectiveness of the diversification of trading across many markets.

www.FXStreet.com The Significance of Position Sizing

Akkizidis Nikolaos

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