Thread by @technovestor

Position Sizing and Trading Performance
What is the value of the position you are carrying? When we say value, it has nothing to do with margin, risk, where your stop loss is, etc. When we are talking about the world of cash equities, this is quite clear. The importance

arises when we are trading futures and options, which is more the case. Let us see this in context of Cash equities, Futures and Options.

Let us say we are buying 1000 shares of XYZ Ltd. For Rs. 500/- a share. The exposure totals to Rs.500 (The price)

X 1000 (The quantity bought). That totals to Rs.5,00,000/-. This is the position size, or in other words “exposure” to the market. The maximum a share can go to is 0. So this is also the “Risk” i.e. maximum that one can lose in this position. To take delivery of this

position, i.e. buy these shares and hold them overnight, when we talk of an account without any leverage, we need to pay Rs.5,00,000/- and in return we will get the equity shares worth that value in our account.

Now let us assume this same position was in futures instead of

cash. And 1 lot of futures is equivalent to 1000 shares. Now when we buy the futures, the exchange levies a margin, which, let us assume, is 20%. What this means is that to take this position in futures, i.e. buy 1 lot, we need to deposit with the exchange :

20% of 1000 (the quantity of underlying shares or Lot Size) * Rs.500/- (The price)

= 20% of 5,00,000/-
= 1,00,000/-

The moment we are buying a future, now there arises the question of leverage and exposure, and the dimension of position sizing starts becoming important.

This position carries a leverage of 100 / 20 (The margin %) i.e. 5. What this means is, a 10% gain or loss in the share will cause a 10% * 5 i.e. 50% gain on loss on our margin amount (the amount of Rs.1,00,000). A 20% move will cause a gain or loss equivalent to our margin

amount (i.e. 100%) of Rs.1,00,000 on this position. In other words, if one traded with 1,00,000/- capital and bought this lot, and the stock fell 20%, the account would be wiped out.

To understand the risk above with the future, we can also think of it like buying shares in the

first case, where the maximum possible loss was Rs.5,00,000/-. This can happen if we buy the future and the future falls 100%, since the exposure to the market is Rs.5,00,000/- for the future. If the account had Rs.1,00,000/- Capital, the loss would be 500% of capital.

That’s where when we read fine print, we can see read futures trading may result in losses beyond the capital used to trade it.

Why is sizing important here. The reason is that once exposed to futures i.e. where the possibility of leverage is more than 1,

one may tend to forget the value of position we have taken (the exposure, risk a.k.a Rs.5,00,000/-). Both professionals and amateurs are equally prone to forget the dynamics of leverage and exposure. Professionals train themselves more and more to be cognizant of this fact.

Trading firms have in place a middle office or risk management whose job is to keep the exposure and leverage levels in check.

If one had a capital of Rs.5,00,000/- and bought this 1 lot of future, he or she now has a leverage of 1 because the value of position is equivalent

to the value of capital. If one had a capital of Rs.2,50,000/-, the leverage would be (the position value 5,00,000 / the capital 2,50,000) i.e. 2.

With options, the leverage factors can increase tremendously, and hence even more is the important of position sizing.

Continuing with the same stock, say buying a Call Option of 500 Strike costing Rs.10 would involve us to pay 1000 (the Lot Size) X 10 i.e. Rs.10,000. If with Rs.10,000/- in the account, a person buys this, the leverage is (5,00,000 the position size/ Rs.10,000) i.e. 50 times.

That is the killer leverage available. Why killer? One could argue that look, a 1% move in favour would return us 50% on capital! True!! But similarly a 1% against move would result in a loss of 50% of capital, and a 2% against move would wipe of the account i.e. Rs.10,000/-

of premium. Is options, then bad. Or worse than futures. Is futures then bad, or worse than cash. Nothing like that. Every instrument has it’s pros and cons. With options, as a buyer, the good thing is that maximum loss is limited to Rs.10,000/- (The premium paid) in this

case. So if you had 5,00,000/- capital and traded this position, maximum loss would be 10,000/ 5,00,000/- i.e. 2% of capital. Even if the stock fell 20% or 50%, maximum loss would remain 2%. However a gain of 20% or 50% could result in earning Rs.1,00,000/- or Rs.2,50,000/-

which is 10 times or 25 times the premium. Or in other words 20% or 50% of capital.

How is all this linked to Trading Performance. Whatever system one follows, theoretical (i.e. system) profits v/s realised (actual) profits have a lot to do with the position sizing used.

If size is too high, we would, sooner or later, abandon the system or over-trade. If size is too low, sooner or later, we may find it un-meaningful to trade and either increase size randomly or abandon the system.

So getting the right position size is so very important to

trading performance. The right size should be one that does not affect you so much when the position loses and gives you a gain which is meaningful enough. It is one which allows us to take the next trade with same planned size irrespective of outcome of previous trade.

What is right for you? Each one has a different stomach or gut. That’s where the capacity to take risk comes from. You need to find the right leverage according to your stomach or gut. I have observed, under most situations,

my actual capacity to take risk is half of what I perceive my capacity to be.

To find a Method in the Madness, work on your position size. It will pay off manifold.

Apparently 30% to 40% importance for any systematic trading is this less talked about but most important aspect

called #Position #Sizing

#TradeRightSize
#StickToPlan

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