Position Sizing: The big and the small

In my book, position sizing is the most important part of trading. To trade is to gamble, and sizing controls the gambler's natural instinct to shove all the chips on to a single lucky number before the wheel is spun.

Trade sizing is addressed high up in my Trading Rules (available here as a Google doc):

Each initial position is one unit valued at one-hundredth (1%) of capital designated for this strategy divided by the 20-day Wilder average true range (ATR), with all values rounded down if needed. Each position is limited to four units

But sometimes, the rules don't work.

At very high or very low prices, the ATR sizing method breaks down. Either the size of the unit is ridiculously small in comparison with the huge share price, making a trade within the rules impossible. Or the unit will allow a ridiculously high number of low-priced shares, and so also not can't be traded because of insufficient liquidity in the market.

This method of adjusting the unit size for the volatility of the stock is derived from the original Turtle Trading method of the 1980s and was a simple way to make the calculation back in the days when the combination of computing power and networking that traders rely on today simply didn't exist .

These two examples assume a relatively well-to-do retail trader who has managed with, say, $100,000 in trading funds. Definitely not in Occupy's 1%, but not in Mitt Romney 47%, either. Those funds mean that the base size of one unit is $1,000.

1) Apple Inc. (AAPL) closed today at $437.60, with an ATR of 11.02. Dividing $1,000 by the ATR gives a unit size of  $90.74, or about 1/20th of a single share.

2) Rainmaker Systems Inc. (RMKR) closed at 43 cents, with an ATR of 0.04, for a unit size of $25,000, or 58,139 shares, nearly 70% of the average daily volume.

One way around the problem with high-priced stocks is to trade option spreads instead. I trade short vertical spreads typically and determine the unit size by dividing the maximum loss on the spread by the ATR. Since options are leveraged, the unit size will work out at levels where the stock price is too high to trade.

However, that won't work with a price as high as AAPL's, where the unit size is still too small. It also won't work with the low-priced symbols, which generally lack options.

My second method, for high-priced stocks, is to treat my single entry transaction as four units, the maximum I allow myself, and to forego adding to the position if the it moves in my direction. That means I can do a trade that's four times riskier than the rules would allow.

For low-priced stocks, I define my entries in terms of fractions of a single unit and increase the number of times I can add to the position. Normally, it's four times, but if in the case of RMKR I defined a unit as $1,290, or 3,000 shares, then I could add nearly 20 times, if the chart supported such action.

(See the "Additions" section in my rules for details on when I add to positions.)

My third method is to, well, cheat. If I like a stock a lot and the best I can do on the unit is 0.45, then I'll cross my fingers and open the position. Or the stock is priced so low that there's no reasonable addition limit, then I'll wing it. I really don't like to break sizing rules, but ultimately, I hate losing an opportunity even more.

I'm considering replacing the ATR in my rules by some other method of adjusting for volatility, either the beta or a combination of implied volatility on optionable stocks and beta on the others, but I need to do some testing before making a decision. Meanwhile, nearly all the stocks that come up on my radar are within reach of most traders.

References
My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.