Portfolio Management: Three Ways To Size A Position To Meet Your Needs

Sizing is a key concept in portfolio management. Limiting a single position’s size can help prevent excessive losses. At the same time, distorting a position’s size can enhance performance, assuming the stock appreciates vs the S&P.

Here’s how it works. 

First, investors should consider their risk tolerance, the stock's volatility and liquidity, and their overall portfolio diversification when determining the appropriate position size for a stock.

One of the simplest ways to size a single stock is to limit it to no more than 5-10% of a portfolio. Some investors choose more conservative strategies, narrowing their exposure to any single stock to just 1-2% of a portfolio. This strategy tends to be used in portfolios with a high number of stocks. 

A second approach to position sizing is the "risk per trade" method. This involves determining the maximum amount of money you’re willing to risk on a single trade, and then dividing that amount by the stock's stop loss level, which is determined by a moving average or a percent decline from its current price. This serves as a price at which you would lose the maximum amount of money. The result is the number of shares that can be purchased without exceeding your maximum risk per trade.

For example, if you have a maximum risk per trade of $1,000 and a stock trades at $120 with a stop loss level at $100 per share, you could purchase up to 10 shares without exceeding your maximum risk. The strategy helps you to avoid risking more than you can afford to lose on a single trade.

A third approach to position sizing is to use the "volatility-based position sizing" method. This involves calculating a stock's average true range (ATR), which is a measure of the stock's volatility over a specified time period. The position size is then determined by dividing the maximum risk per trade by the ATR. This requires some more math and an understanding of technical analysis.

The basic formula for calculating position size using the volatility based method is:

Position Size = (Risk Per Trade / ATR) * Position Sizing Factor

The position sizing factor is a number between 1 and 3 that reflects an investor's risk tolerance and confidence in the trade.

For example, if an investor has a risk per trade of $1,000 and the ATR of a stock is $2.50, and the investor uses a position sizing factor of 2, then the position size would be:

Position Size = ($1,000 / $2.50) * 2 = 800 shares

Remember that stocks with high volatility may require smaller position sizes to limit risk, while less volatile stocks can handle larger position sizes.

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