Three Steps To Perfectly Sizing Your Positions

Stéphane Renevier

about 1 year ago7:28 mins

Three Steps To Perfectly Sizing Your Positions

What’s going on here?

Tactical trades are the ones that involve profiting from your short- and medium-term views. These could be macroeconomic perspectives on things like inflation and interest rates, or stock-specific standpoints – such as predicting an earnings-related price pop.

But capturing shorter-term opportunities you see in markets obviously requires a slightly different approach to size than the one you use to manage your long-term passive portfolio. If your core portfolio is a tank, this Insight is about how to position your snipers – and how much to spend on them.

What does this mean?

To employ another metaphor, imagine you’re investing with a common “core-satellite” setup. You’ve got $8,000 strategically stashed in exchange-traded funds (ETFs) tracking global stock and bond markets – but you’ve also got $2,000 cash on hand ready to trade your tactical market views.

Let’s say that you’re thinking of spending some of that on a certain commodities ETF that looks like rising in the near future thanks to inflationary pressures. This Invesco DB Commodity Index Tracking Fund (ticker: DBC) is currently trading at $16. How much do you allocate to that idea?

Step 1: Determine how much you’re willing to lose

Three factors are crucial here: your level of conviction, how diversifying the idea is compared to the rest of your portfolio, and the volume of tactical trading you’re already engaged in. The more convinced you are of the trade and the stronger its diversification benefits, the more you can reasonably risk.

As a rule of thumb, I’d recommend risking no less than 0.5% and no more than 5% of your “active budget” on any single trade. If you’ve got a strong thesis on commodities but appreciate the trade’s limited potential for diversification (as the performance of both commodities and global stocks is dependent on strong economic recovery), you might risk 3% on the ETF in our example.

3% of our $2,000 satellite budget would mean that we’re risking $60 on this short-term view. That might seem a little low – but remember, at this point we’re still focused on how much we’re willing to lose, rather than finding the final amount we’ll actually buy of the ETF (we’ll get to that in step 3).

Step 2: Determine when you’ll sell if things go wrong

The goal here is to find the price that proves your thesis wrong. This obviously depends in part on the rationale for your trade: if it’s a short-term bet and you’re confident in your timing, then setting up a tight automatic sell (a “stop-loss”) at $15 could do the job in our example.

If, on the other hand, you’re happy to trade on a slightly longer timescale, then you’d be better off using a wider stop: $12, for instance. That way you’ll stand to benefit even if there’s a blip in the immediate future.

Whatever your choice, it’s important to select a stop that’s broad enough to accommodate meaningless “market noise”. For further clues on where to set your stop, you might want to look to technical indicators:

  • Percentages: you could set the stop, say, 15% below the current price: at $13.60 in this case.
  • Volatility: you could look at either the investment’s volatility or its average true range (ATR) over the past 20 days and set your stop 5-10x that level below the current price – so between $14 and $15 in our example.
  • Technicals: examine key support and resistance levels. Here, $12.50 hasn’t been breached in a while – so our ETF falling below that would likely be a signal to sell

Let’s say that, based on the above factors, we decide to use $14 as our stop-loss level. If we buy one share of the ETF at $16, then we’re clearly only risking $2 on the trade. Of course, the reality is a little messier: you could incur slippage and your execution price could end up lower, particularly in extreme market conditions. I recommend adding a small margin of safety to account for that.

A stop-loss at $14 means we’re risking $2 for each share of the ETF we buy (Source: Teletrader.com)
A stop-loss at $14 means we’re risking $2 for each share of the ETF we buy (Source: Teletrader.com)

Step 3: Use those figures to determine your position size

In our tactical trading example, we’re willing to risk losing $60 – and our stop-loss level means we’re risking $2 for each share we buy. So how many shares does that make?

Shares = Total Risk Appetite (Step 1) / Risk per share (Step 2)

In this case, 60 / 2 = 30 shares. At $16 a share for our commodities ETF, that amounts to a total exposure of $480 – or just under a quarter of our tactical satellite budget.

Interestingly, if we’d used the tighter stop-loss level of $15 then we could have bought 60 shares instead (60 / 1). That’s worth bearing in mind: while in both cases you’d be risking the same total amount ($60), there’s a trade-off to be made between potential profit and the probability of stopping out at a loss. A twice-tighter stop loss could see you make twice as much – but there’s a correspondingly higher risk of losing money.

Why should I care?

Many investors underestimate the importance of careful position-sizing: they just put a round percentage of their tactical stash in a stock and figure it out later. But in my opinion, spending just a bit more time considering exactly how much to buy could significantly improve your investment process – and potentially your results.

While it’s important to highlight that this is only one of many ways to size tactical trades I think there are three main advantages to using this method:

It forces you to define in advance at what level you’ll exit the trade, helping you limit your potential losses.

It allows you to focus on exactly how much you’re risking every time you make a trade.

It makes you think hard about your investment rationale. How confident are you about timing your entry? When will the market prove you wrong? Are you keen to maximize your odds – or gamble on bigger gains?

Tactical trading isn’t for everyone. You may very well be content passively invested in indexes and a few individual perpetual picks. But for those looking to monetize their shorter-term market views, doing so with a real process in place could add up to significant long-term success.

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