Position Sizing with Defined-Risk and Undefined-Risk
Position Sizing with Defined-Risk and Undefined-Risk
When you trade too large, it’s difficult to think clearly and nearly impossible to remain objective
- Nothing can do more damage to your portfolio than trading too large.
- With defined-risk strategies, keep your positions to 1%-3% of your total account value.
- With undefined-risk strategies, keep your positions to 3%-7% of your total account value.
Nothing will do more damage and completely derail your trading efforts more quickly than oversizing your positions. When you trade too large, it’s difficult to think clearly and nearly impossible to remain objective throughout the inevitable twists and turns of the market. To give yourself the best possible chance to succeed in the long-term as a trader, nail down your position sizing. This is non-negotiable.
Defined-risk position sizing
With defined risk strategies, or really any strategies, you never want to put yourself in a position where you can’t manage the trade the way it was intended to be managed. And the No. 1 way to make sure that doesn't happen is by staying small on order entry. But how small is small? That largely depends on your account size. Generally speaking for an average account ($20,000 to $100,000), starting with defined-risk strategies, a great reference point is to be between 1%-3% of your account value per position. This size is plenty small enough to manage the trades as they ought to be managed.
If you have more than $100,000 in your account, then you’ll likely be able to shrink your defined-risk trades down below 1% of your account at times. If you have less than $20,000 in your account, you’ll likely have to increase the upper end of this range, hitting 5%, 6%, 7% or even higher at times.
Undefined-risk position sizing
With undefined-risk strategies, such as short puts, short strangles, or ratio spreads, the very nature of the strategy requires that you allocate more buying power per position. Generally speaking, for an average account size between 3%-7% is plenty small enough to trade your naked positions objectively and give the probabilities time to play out.
If you have more than $100,000 in your account, you’ll likely be on the lower end of this range with your positions. If you have less than $20,000 in your account, you’ll not only be on the higher end of this range but you’ll also likely have to increase the upper bound. Some undefined-risk positions might require 8%, 9% or even 10% of your account value to hold.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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