Position Sizing

Much of our day-to-day trading effort is spent on finding good setups and entering them.

However, the most significant factor and differentiator in trading performance is the position size you enter and trail with in a trade.

Size Matters :

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Position size for most traders is not a static percentage of the portfolio (e.g. 10% size in every trade). Rather, it is a derivative of the % risk taken on the trade and stop loss.

The placement of the stop loss in-turn depends on the following -

Setup type:Certain setups, such as EPs or IPO bases, are inherently more volatile and may require a wider stop loss, compared to range contraction setups.

‍Trade Objective:Trades that have a strong reason (WHY) to break out and are held for longer positional plays can afford a wider stop loss. In my opinion, setting an initial stop loss above 4% can reduce the trade's expectancy. Instead, I prefer to wait for a better pivot and use a tighter stop loss.

‍Entry: Identifying and entering a breakout early provides a significant edge with a tight stop loss and a more favourable risk-reward ratio.

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Let's take some examples with basic math:

Case Study #1 - JBMA,  February 2023

Setup: The stock is breaking out of a well-constructed, year-long base and forming a Volatility Contraction Pattern (VCP) on the right side of the base. On February 16th, the stock formed a very tight day on low volumes.

Trade Objective: Will look to buy and hold the stock for a longer positional play due to (a) Breaking out of a year-long constructive base after a strong stage 2 up move in 2021. (b) Strong relative strength (c) Strong sector news (d) Multiple pocket pivots - signs of big accumulation.

Risk on Trade: 0.5% of portfolio

Selling Rule: Sell 30% of the position in strength at 4R getting stoploss to cost (the markets were bearish and portfolio was flat in Q1 CY2023), and trail the balance position with 21ema. If there is a parabolic move, sell the entire position if the low of the previous day within the parabolic move is broken.

Entry - 17th February 2023

Tight (Green) - Entry 532, Stop Loss 2% - 521.35 (~Day low), Size - 25%

Moderate (Orange) - Entry - 550, Stop loss 5% - 522.5, Size - 10%

Wide (Red) - Entry 568, Stop Loss 8%, - 522.5, Size - 6.25% (triggered on 20th February)

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Sells:

‍Tight (Green) - 30% Sell at 574.6 (4R) + 70% Sell at 1440 - (85R) =60.7R

Impact on Portfolio - ~30.4%

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Moderate (Orange) -  30% Sell at 660 (4R) + 70% Sell at 1440 - (32R) =23.6R

Impact on Portfolio - 11.8%

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Wide (Red) -  30% Sell at 750 (4R) + 70% Sell at 1440 - (19R) =14.5R

Impact on Portfolio - ~7.25%

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Comments:

• The stock has moved over 150% from its base till July 7th, 2023. However, using a moderate or wide stop loss and selling into strength significantly reduced the trailing size, resulting in a much lower impact on the portfolio (11.8%, 7.3% vs 30.4%). This was despite the sell strategy capturing the majority of the move. To increase the size, you would have had to increase the risk per trade.
• Increasing the percentage of selling into strength (from 30% to, say, 50%) would further reduce the percentage impact of the portfolio in a moderate or wide stop-loss position.
• A tighter stop loss would increase the volatility of your equity curve, but in a magnitude move which is sold in weakness, it has a big impact on your portfolio. A pullback with a moderate and wider stop loss can wipe off a significant portion of gains.

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Case Study #2 - Prakash Industries, August 2023

Setup - This strong trending stock is currently moving alongside the 10ema and is now basing after decent results. Momentum Burst, Velocity trade, Flag, VCP - call it whatever you want.

Trade Objective - This is a short-term or swing trade, as the stock's uptrend is not new.

Risk on Trade - 0.5% of portfolio

‍Selling Rule - Sell 50% of the position when the stock is strong at 4R, and trail the remaining position using either the 10EMA or 21EMA, depending on the stock's behaviour.

Entry - 21st August 2023

‍Tight (Green) - Entry 92, Stop Loss 2% - 90.2 (~Day low), Size - 25%

Moderate (Orange) - Entry - 94.4, Stop loss 4% - 90.6, Size - 12.5%

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Sells:

(Trailing position taken at unrealised profit as on Friday Close)

Tight (Green) - 50% Sell at 99.4 (4R) + 50% Open at 121.15 - (16R) = 10R

Impact on Portfolio - ~5%

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‍Moderate (Orange) -  50% Sell at 109.5 (4R) + 50% Open at 121.15 - (7R) = 5.5R

Impact on Portfolio - 2.75%

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Comments:

• The stop loss for a late entry at 94.4 (or any entry above this) has been set at the day low - the closest logical level. Tightening the stop loss did not make sense here because the breakout was clean on intraday charts and could have easily shaken the position out. A tight stop loss should be accompanied by a tight entry. Entering a trade late with a tight stop loss is an inefficient trade management strategy with a low probability of success.
• The breakout (so far) is a dream come true for a swing trader. However, if you use a moderate stop loss or enter the trade late, your returns will be much lower compared to using a tighter stop loss. To increase size, you will have to increase the % risk per trade.
• If timed well, the best trades are instantly profitable without ever dipping below cost. As Dan Zanger said, “winning horses don't back-up into the gate".

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Caveats

• The objective of the cherry-picked examples is not to advocate for one trading style or person over another. Rather, it is to highlight that each confirmation required for execution comes with its own costs. These confirmations include expanding your stop losses, selling into strength in a positional move, or waiting for a trend line to break before entering. While you may not notice it on a trade-to-trade basis, over the long term, these costs compound significantly and hinder your performance.
• One argument against entering a trade early with a tight stop loss is that you may get shaken out of winning trades. While this is partially true, it is a skill that can be improved through post-trade reviews and practice. For now, I suggest conducting a journal analysis to determine the R multiples lost due to adding a cushion to your execution. Then, compare this with the R multiple that would have been lost if you had been shaken out by a tighter stop loss and missed out on a winning trade. In most cases, the R multiples lost in the former case are far greater than those in the latter.
• As a general rule, I cap my per-trade position size at 40% of my portfolio. Additionally, if I do not have an adequate profit cushion before results, I will reduce my position size.

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Takeaway

Not every good setup or technical pattern is a trade, and not every trade is a technical pattern or a setup. As a trader, your task is to understand the language of charts and then refine the details of your executions to maximize the risk-to-reward ratio. Many of these refinements cannot be found in rule-bound technical books, but rather through first-principle observations and creativity.

Don't replicate the rules of US traders, who have a 4x larger liquid stock universe than we have in India, with much lower margin restrictions. If you observe some of @Qullamaggie  streams in bull markets, you will see him holding more than 15 positions often.

There are primarily two ways to achieve super performance in the Indian markets: either size big and hold for a big move, or size big and make many small moves. Taking many small trades and churning for profits is not a great option.

When it comes to trading, everyone has their own preferences and risk appetite. However, there are some ground rules that you need to follow if you want to achieve super performance. Don't make your approach so "comfortable" that it removes the possibility of achieving super performance.