Position sizing essential for risk management

Position sizing and risk management become the cornerstone for success in stock market. An ideal position size has a great balance between your psychological profile and your risk profile. It is important with respect to the kind of moves that happen in stock market.

Suppose we have X number of shares in a particular stock. Assume that there is a gap-up on the next day. The trade would move on your favour and you definitely book very good decent profit. On the contrary if you have a short position and market gaps up then that would amount to a huge loss.

In such scenarios one loses anywhere between 10 to 30 per cent in one single trading session. In case of gap-up or gap-down you are bound to lose or make money in huge amounts.

This is where in position sizing becomes very important. Position sizing again depends on whether you are a short-term trader or a long-term trader.

Let's see the position sizing strategy for long-term trading. For long-term trading, you plan equal value position sizing. Assume that you have an account size of Rs 1 lakh. In this strategy you will allocate equal capital to stocks.

For example, if you are planning to invest in 20 stocks then each stock would get an allocation value of Rs 5,000. We arrive at this figure by dividing account size by the number of stocks.

In this principle now, you invest only Rs 5,000 per trade. Positional traders, swing traders and long-term traders benefit from this way of position sizing.

In the second method, there is an equal risk approach. In this strategy, we identify initial stop-loss first and decide how much to risk. Assume you have an account size of Rs 1 lakh. Under this method, we allocate equal risk per trade. Risk is defined as a percentage of risk of account per trade.

Therefore, two per cent risk per trade on Rs 1 lakh comes to Rs 2,000. Position sizing is calculated by dividing risk per trade with difference of entry (assume 100) and stop loss (assume 20). Position sizing is obtained by dividing 2000 with (100 -80) which is equal to 2000 divided by 20 equals to 100.

However, it becomes difficult to calculate positions in live market because the entire focus of the trader is on identifying the entry points and exit points, maintaining a stop loss and various other factors.

If we prepare an excel sheet on the basis of the above information, then it becomes easier for us to trade in live market.

(The author is a homemaker who dabbles in stock market investments in free time)