Use Small Position Sizes to Manage Risk and Improve Trading Psychology

I’m a private, retail trader, meaning I trade my own money for myself. Most of my money is in conservative, long-term investments, but I also have a smaller account for trading individual stocks.

Trading Stocks in Strong Uptrends

In my trading account, the primary strategy is long-only positions in US stocks which are experiencing strong uptrends. I’ll typically hold these positions for several weeks to a couple months, depending on whether I’m stopped out or hit my price target.

To be in a strong uptrend, the stocks typically have experienced at least a 25% gain in the last quarter. These stocks are clearly experiencing a strong imbalance of demand over supply. The types of companies which typically experience these strong uptrends include high technology (e.g. software, internet), biotechnology, or drug companies. These companies are often participating in a “game changing” business trend, such as cryptocurrencies or electric cars.

Companies experiencing strong uptrends are often on the bleeding edge of a new technology, a new medical treatment, or some other important innovation. Unfortunately, to the extent these companies are pushing the envelope, there can also be failures and setbacks. For example, a biotechnology company may not get the results they were anticipating for a new treatment, significantly impacting the company’s future business prospects. Or a drug company many fail to gain FDA approval for a new drug. When this type of negative news is reported, the stock’s price may gap down by a significant percentage, exposing shareholders to a significant loss.

Position Sizing is Critical to Risk Management

One of the first rules a trader will likely learn is to always use stop losses to manage risk. There’s also a rule to risk no more than 2% of an overall trading account value on a single trade. For example, if 25% of an account is invested in a single trade, with an 8% stop-loss, the overall trade will risk 2% of the account’s value.

Undoubtedly, the 2% rule and stop losses are very important for risk management. However, they don’t address the risk of a stock’s price gapping through the stop loss price, or slippage when there is not enough liquidity to fill the stop loss order at the desired price.

In the case of my own trading account, I typically never invest over 10% of my trading account value in a single trade. Across my account, I’ll invest in anywhere from 10 to 15 positions, each of them being relatively small. This protects my overall account from the catastrophic events of a single position. I’m also very careful about trading on margin.

Using Volatility Based Position Sizing

One helpful risk management technique is to size the position based upon volatility. Instead of using a fixed percentage of a stock’s price for a stop loss, or investing a fixed percentage of the account value in each position, use a multiple of the stock’s recent average volatility to calculate a stop loss (determined using the ATR indicator). At the same time, keep the capital at risk well below 2%.

For example, assuming you have a $100,000 trading account value (including both cash and market value of current positions), want to risk no more than 1% per trade, and the stock’s average volatility is $2:

• The total amount at risk for the the trade should not exceed $100,000 * .01, or $1000.
• To risk no more than 2 times the average volatility, use a stop loss of $4 per share.
• To risk no more than $4/share and a maximum of $1000 for the entire position, the maximum position size would be $1000/$4, or 250 shares.

Speculative stocks, such as biotech companies or drug makers, are typically quite volatile to begin with. Therefore, using this technique, the resulting position sizes will tend to be smaller than less volatile stocks.

Further Reducing Position Sizes

Using a volatility based stop loss and the 2% rule still doesn’t handle the worst-case scenario when the price gaps through the stop loss price. To begin to address these worst-case scenarios, the position size can be reduced further.

The approach I take is to limit the overall capital I’ll invest in a single trade to 10% of my trading account value. In particular, if the current share price times the number of shares to be invested exceeds a maximum overall amount to put at risk, the position size is further reduced.

Expanding upon the example above, and assuming the current share price is $80:

• Purchasing 250 shares would cost 250*$80, or $20,000. In a worst-case scenario, this entire $20,000 would be at risk.
• However, if the position size was cut to 125 shares, only $10,000 would be invested in the position. Further reducing the position size like this means in a worst-case scenario, the most you could lose is 10% of your trading account balance.

Smaller Position Sizes Also Helps Trading Psychology

When I first started trading, I used larger position sizes and held only 4–5 positions in my account. With larger position sizes, the price fluctuations could be jarring.

Besides controlling for the financial risk of negative news impacting a stock’s price, orienting towards smaller position sizes also helps with trading psychology.

Simply put, if I have a 10–15 relatively small positions in my account, I won’t lose sleep over any single position. Smaller position sizes give me what I call a “healthy level of indifference” to the price fluctuations of a single position. Using smaller positions, I now have more conviction to hold onto a position and let it proceed according to plan. With smaller positions, I’m also not watching the price constantly, which only contributes to impatience and emotions; in other words, a watched pot never boils.

In general, it’s been surprising to me how small changes to risk management can have such a large, positive impact on trading psychology.

Summary

Traders will inevitably be exposed to low probability, high impact events which could have a catastrophic financial impact on their trading account. In these events, price will often gap down through a stop loss price, so a stop loss order is insufficient to manage risk.

When a position is held overnight and a significant price movement occurs, smaller position sizes limit the financial risk to the overall trading account. Smaller position sizes also help with trading psychology. If an account has a multitude of smaller positions, a trader can keep a healthy level of emotional detachment from individual positions, while maintaining the patience and conviction needed for disciplined trading. Based upon my own trading experience, the importance of smaller position sizes cannot be overstated.