Sizing your positions correctly is one of the most important aspects of risk management in trading. You ideally want to strike a balance between having a position size big enough that it will count if your trade is a winner, but small enough that any loss is not too great when you need to execute a stop loss..
This is a difficult balance to strike as it often interferes with our ability to manage fear and greed.
Our brains are naturally wired to fear losses, but to become greedy when it comes to winners. Yet so often the way many amateur traders behave is counter to that thinking.
The late Dr David Paul once said to me on a podcast interview:
“The difference between winning traders and losing traders is that when losing traders have a winning trade on, they become pessimists – fearing that their profit will disappear. When they have a losing trade on, they become optimists – hoping that their loss will turn around, and maybe even add to their losing trade. On the other hand, when winning traders have a winning trade on, they become optimistic – they run their winners and add to them. When they have a losing trade on, they become pessimistic and size down or close the trade completely.”
This has always stuck with me as have many of the things I learned from the great Dr David Paul who sadly passed away in early 2023.
Over the years I have tried a variety of different position sizing methods. When I was younger, I’d often size my trades too big and would thus have major swings in my P&L as a result. Winners could be great, but losers really hurt badly.
I’ve learned to size trades more conservatively as I’ve grown older, and to try to remember that each trade is just one of the next 1000 trades.
Some traders try using ultra-tight stop losses in order to maximize position size. The thinking is that they will be right in a big way if their trade works, but if they get stopped out, the stop loss will be tight and thus the loss won’t be too great.
The trouble is that for a vast majority who try this approach, they end up getting chopped to death on every small market movement, even if the market ultimately moves in line with their original thinking. This is very frustrating and ultimately does your financial and emotional capital no good.
A better way to avoid this frustration is to start positions “small and wide” and then get “bigger and tighter”. This means a small starting position with a wide stop loss (perhaps 1/3rd to ½ of your intended size), and then if the trade moves in your direction, you add to it and tighten the stop loss as the price action moves in your favour.
If the trade goes against you early on, the wider stop loss will allow you to see through the small market movements and avoid getting chopped up on those small movements. And if you do happen to get stopped out at the wider stop loss, then it will mean that your loss isn’t too great as your position size was still at its smallest.
Never add to a losing trade. The “bigger and tighter” part refers to pyramiding your position size upwards as the trade moves in your favour. But again, don’t adjust the stop loss too tight. You want to still be able to allow the position space to breathe and to avoid getting chopped up by small market fluctuations.
In my experience, I’ve collectively made more profit on small positions that I’ve been able to run, than I have on large positions that I have battled to hold onto. That’s because the emotional toll of riding the big P&L swings on a large position inevitably catches us out when the pain becomes too difficult to bare.
You’ll be amazed at the amount of money that can be made over time on small positions that allow you the mental strength to run winners.
Remember, start small and wide, and get bigger and tighter.