Size Matters

I was corresponding with one of the TWR subscribers last week and he had questions about the performance numbers I publish on the final page of each report. Specifically his question was, “Are you saying that if I had followed all of the trade ideas so far this year that I would be up 18.8% year-to-date?”

My answer was, “it depends.”

We went on to have an in depth conversation about position sizing and it occurred to me that it might be worth using this space to walk through the concept of position sizing and some of the factors that can influence it.

Despite the 2.6% decline in the S&P last week and all of the media coverage wondering, like Fred Sanford, if this is the “big one,” last week was an extremely slow week and there were no material changes to global fundamentals.

Skin In The Game

So, let’s dive in to position sizing. I’m going to assume a portfolio value of $100,000. The cumulative performance numbers that I publish on a weekly basis are more an opportunity set rather than the returns of an actual portfolio.

How each of you decides to trade the ideas that I give you will dictate the actual return to your portfolio. Using the $100,000 portfolio and the current list of open trade ideas, I’ll show you what I mean.

There are essentially two ways to size positions:

1. The Allocation Method. The allocation method involves simply sizing each trade idea using a fixed percentage of your account. For example if you allocate 20% of your account to each trade idea here is what your account would currently look like:


You can see that the opportunity set of the current group of open trade ideas is 8.46%.

You currently have half your account invested. You initially risked a total of 1.1% of your account and you currently have a gain of 1.66%, so your reward to risk ratio is approximately 1.5-to-1.

The main problem with this method is that there is no accounting for the risk of each individual trade idea. So in the example above, your risk per trade idea varies from 0.49% on the first FXI short trade idea to 0.06% on the second GLD long trade idea.

In this example if all 5 trade ideas turn out to be losers you'll lose a total of 1.1% on your account, which in most circles is extremely conservative. Risking 1.1% of your account on a basket of trades doesn’t allow for a lot of upside potential if you turn out to be correct with your ideas.

It’s always a balancing act between risk and reward but if you’re going to make a trade, make it count. Risking 0.5% on one trade idea is fine but to go to the effort of evaluating, executing and monitoring a trade to risk 0.06% or 0.12% of your account is a waste of time.

You're better off not making the trade.

A quick word about risk: The amount you “risk” in a trade isn't the amount of principal you put into a trade idea.

For instance, the first GLD long trade idea has a risk of $327, not a risk of $18,811. Yes, there's a potential that GLD may gap below the risk price one morning but it won’t gap down 100%.

Start equating “risk” to the amount of money per share that you're risking between where you're entering a trade idea and where you will exit if you are wrong and how that loss will impact the overall account; not the principal amount of money you've invested.

The allocation method is not my favorite for a number of reasons. However, if you are trading in an IRA account or another account that does not allow margin, it may seem like the best option for you.

2. The Trader's Method. I would encourage you to think about modifying this method to suit the type of account you're trading. The trader’s method is focused on keeping the risk per trade idea consistent no matter which Focus Market you're trading or what the particular risk is for that trade idea.

I’m still going to start with the same $100,000 hypothetical account but this time I’m going to risk 0.21% per trade or $210. We have 5 open trade ideas, that means if all 5 trade ideas turn out to be losers, my account will lose $1,100 or 1.1%. Here’s what the account looks like using the Trader’s Method:


We still have the same 8.46% opportunity set as before, but this time our current return is 4.15%, which is greater than the gain using the Allocation Method and improves our reward to risk ratio from 1.5-to-1 with allocation to nearly 4-to-1 with the trader’s methodology.

How is that?

The first thing you’ll notice is that we have total principal invested of $185,290. How is this possible with a $100,000 account? Leverage.

Most taxable brokerage accounts allow up to 6x the cash value to be traded and held overnight. Now I’m not suggesting you immediately open up for a margin account and start trading using leverage. The purpose of this exercise is to help you start thinking about “risk” of your trades in a more constructive manner and to show you the difference in profit potential using the Trader’s Method.

You’ll notice that even though I've invested $85,000 more than the account value, the risk to our portfolio if all 5 trade ideas are losers is exactly the same, 1.1%. Yet, our current gain of 4.15% is nearly 3x greater than using the Allocation Method and we've captured approximately half of the opportunity set.

So, again, the most important “risk” to monitor is your cumulative risk per trade for the whole account, NOT the total amount of principal you've invested.

Take the second GLD long trade idea. You may have 70% of your account invested in that idea, but you’re still only risking $216 or 0.21% of your total account if you turn out to be wrong. I consider myself to be a fairly conservative fund manager and I risk anywhere from 0.30% up to 0.80% on a given trade.

Some fund managers will risk considerably more, risk taking is an individual preference. Here’s what your account would look like risking a slightly more aggressive 0.5% per trade idea:

Again, you can see that while we've invested over $300,000 more than the cash value of our account, the total initial risk is just 2.5% of our account value. In addition, our gain exceeds the 8.46% opportunity set and once again, we have gained nearly $4 for every $1 we risked initially.

Hopefully now you can understand 2 things:

Why the profitability of our trade ideas can vary widely across investors and account types.
The benefit, no matter what type of account you're trading, in thinking in terms of the risk per trade idea versus how much of your account is invested in each trade idea.