Position sizing can save you from committing financial suicide in the sharemarket. Few people realise the importance of this essential skill because, at first glance, the benefits are not immediately tangible.
Money management and position sizing suggests you know how many shares to buy and how much of your account to commit to a given market. Studies have shown that even random entry systems can be profitable using effective stop-loss procedures and good money management. When people begin trading, they often believe that as long as they hitch a ride with a share that is headed for the moon, they will accumulate untold riches. Few trades co-operate to this extent.
Ironically, 90% of my trades do not amount to a significant profit. It feels like I’m treading water, waiting for a trend to unfold. The majority of my profits are produced by just 10% of my trades. Trading is often not a consistent income-generating activity. Many people give up or run out of money before they turn a profit.
It could take you 20 trades in a row of mundane, frustrating, break-even or loss results to hit the one trade that will bring in an extreme profit. There is no ‘normal distribution’ of wins to losses in the market when you look at a small sample size. Money management and stop-losses will help keep you in the market long enough to experience a few terrific winners, even if you hit a cluster of losses.

Sector Risk
If you cannot sleep at night, or if you are continually thinking about the performance of your shares, your position size is too large for you to handle. Be aware, however, that if you own more than one stock per sector, then you are effectively trading the same instrument. For example, if you have four bank stocks, and own call options on CBA, you have ineffectively diversified your trading capital. It is as if you are trading the one position only.
Make it a rule never to trade more than one position per sector. If you don’t, you are opening yourself up to an unacceptable level of sector risk. Your trading account will eventually suffer when the tides turn against your favoured index.
There are several models to help answer the question: ‘How much of my capital should I devote to this trade?’ Each has pros and cons. Ultimately, you need to choose one position sizing model, or a hybrid of the available models, before buying a stock.

Equal Portions Model
This model is where your capital is divided into equal amounts. For example, you may have $100,000 equity and decide to split this into 10 different positions of $10,000 each.
There are some inherent difficulties with this concept. It assumes a consistent risk factor across all trades. This is an illogical assumption. This method will lead to your demise if you trade derivatives. In all likelihood, you will be committing too much equity to an illiquid and complex trade. This is likely to damage your overall trading equity.

The Capital Allocation Model
This model divides your capital between areas of risk. One of the underlying principles behind the market is the theory that if a stock has a significant market capitalisation – for example, top 100 or top 300 – then it is likely to behave in a more predictable fashion. (Market capitalisation is the number of shares that have been issued in total, multiplied by the share price.) The market capitalisation will affect whether a share is included in Australia’s benchmark All Ordinaries index.

How To Use This Model
The maximum number of shares that most people can manage at one time with a larger portfolio, for example $300,000-plus, is about 15 separate positions. People with a smaller portfolio often feel more comfortable holding six to 10 stocks. This is largely anecdotal evidence, because according to my knowledge there is no reliable data regarding the ideal number of shares to hold.
As a guideline, the minimum number of positions in a portfolio should be at least three stocks, in order to give you a chance to learn how to trade well. Hopefully out of those three stocks, at least one will be trending in the right direction, although there is no guarantee.
As a suggestion, it may be best to allocate more money to the top 100 stocks (lower-risk), such as 50% of your capital. You could allocate a moderate amount to the bottom 200 stocks of the top 300; for example, 30% (moderate-risk). The least amount of money (for example 20%) would then be allocated to all other stocks not appearing in the top 300. All derivative trades are also included in this category.
This would mean that from an initial starting equity of $100,000, you could allocate $50,000 to lower-risk shares, $30,000 to moderate-risk shares, and $20,000 to higher-risk shares and derivative positions.
For the sake of simplification, let’s say that you’re happy with holding 10 shares. This could be split into the equivalent of three separate portfolios defined by the risk inherent within the market capitalisation level. Your low-risk portfolio of top 100 shares could contain three stocks, from different sectors, with a position size of $16,666 each. Your moderate-risk portfolio could contain three stocks with a position size of $10,000 each. Your high-risk portfolio could contain four stocks or derivatives with a position size of $5000 each.
Make your capital allocation rules with regard to high-risk areas explicit. You may decide to commit a maximum of only 15% or 10% of your total equity to higher-risk sectors of the market, depending on your risk profile. This will still provide exposure to potential high returns, without bursting the seams of good judgment.
There are refinements to this method, but if you relate to the concept, then this can be a simple way to position size with a higher degree of sophistication than the equal portions model.
There is a principle called the “Kelly principle”, which suggests that you should not have more than 25% of your trading equity placed in any single position on the sharemarket. This is in line with the rationale of minimising the effect of an unforeseeable potential catastrophic event.
Many traders do not utilise the Kelly principle because it seems to be in contradiction to the concept “let your profits run”. However, if your losing trade is conducted using too much of your overall trading capital, you could violate this rule easily. If you appropriately size your positions, then the chance of a one-off shattering loss leading to devastation is slim indeed.
There is a fine line between letting your profits run, and planning just in case a catastrophe strikes. You want to back the winners, but have an efficient threshold that determines when you have placed enough of your equity into a particular position.
The key is to not allow your overall position size to exceed 25% of your total trading capital. Take into account the positions that you hold in different sectors and ensure that their combined size per sector is also less than 25%. For larger portfolios, you could consider keeping overall positions to less than 15% or 20% of the overall trading capital.
Remember to take into account the effect of pyramiding. If you have decided that you would like to add more money to your winning positions, you must make sure that you stay loyal to the Kelly principle.
If you haven’t yet got an effective written trading plan – you need one. Traders who trade without a written trading plan deserve to starve. The game is on. Nobody knows how long your ride will last, but I can tell you – without a trading plan, your chances of survival are zip.

Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. Register on her website to receive a free trading plan template and a 5-part e-course to get you trading like a machine.