Position Size and gaps

[BasicChannel]

Hi everyone,

Thanks for all the info thus far! I'm just getting the ball rolling and have a question regarding position sizing based on a percentage of your trading account.

Assuming the formula "account risk / trade risk = number of shares to trade", there seems to be times when the potential position size could be 70%+ of the account. For example let's assume an account size of $100,000 and a risk percentage of 1%. If we find an opportunity to buy shares at a price of $15, with a stop at $14.8, we're looking at a position size of $75,000 (1,000 / .2 = 5,000 shares and 5,000 * $15 = $75,000).

I understand this is based on your stop exiting you out of the position, however isn't there potential risk of the price gapping below your stop overnight? It seems very risky. Furthermore, this formula doesn't work if our stop remains the same size yet share price increases (5,000 * $21 = $105,000).

Am i missing something here? Thanks in advance for any help.

 

[tomorton]

I think you've got mixed up with your maths.

You wish to buy a full $100,000's worth of shares, and you wish your capital risked to be 1%, or $1,000. So you should look to the selling price of $14.80 per share, in order to size your position. So, your 1% of capital risk limit means you should initially be buying 6,756 shares (100,000/14.80).

As for gaps beyond the stop, yes this is a risk of trading. But the tighter your stop compared to entry, the more often this will happen. Your distance from 15.00 to 14.80 represents only a drop in price of 1.33%, so I guess this sort of gap is going to hit you every few sessions. What is the reason for your stop being so tight? Have you thought about setting a stop based on price chart structures? Have you thought of setting a stop based on a volatility-based indicator like Average True Range?

 

[malaguti]

I think you've got mixed up with your maths.

You wish to buy a full $100,000's worth of shares, and you wish your capital risked to be 1%, or $1,000. So you should look to the selling price of $14.80 per share, in order to size your position. So, your 1% of capital risk limit means you should initially be buying 6,756 shares (100,000/14.80).

As for gaps beyond the stop, yes this is a risk of trading. But the tighter your stop compared to entry, the more often this will happen. Your distance from 15.00 to 14.80 represents only a drop in price of 1.33%, so I guess this sort of gap is going to hit you every few sessions. What is the reason for your stop being so tight? Have you thought about setting a stop based on price chart structures? Have you thought of setting a stop based on a volatility-based indicator like Average True Range?

Me thinks you have your maths mixed up Tom
If you buy 6750 shares at 15 the poor guys blown his account already
@BasicChannel
Take your risk of 1% and divide that by your stop ie 0.2 (15-14.8)
That means you buy 5000 shares costing you 75k
If you then sold at 14.8 you would get back 74k hence your risk of 1%
Assuming of course you had no slippage and a broker would actually guarantee a stop that close

 

[tomorton]

Me thinks you have your maths mixed up Tom
If you buy 6750 shares at 15 the poor guys blown his account already
@BasicChannel
Take your risk of 1% and divide that by your stop ie 0.2 (15-14.8)
That means you buy 5000 shares costing you 75k
If you then sold at 14.8 you would get back 74k hence your risk of 1%
Assuming of course you had no slippage and a broker would actually guarantee a stop that close

you're right - need to think this a bit more....

 

[tomorton]

this might explain quite a few things......

 

[BasicChannel]

I think you've got mixed up with your maths.

You wish to buy a full $100,000's worth of shares, and you wish your capital risked to be 1%, or $1,000. So you should look to the selling price of $14.80 per share, in order to size your position. So, your 1% of capital risk limit means you should initially be buying 6,756 shares (100,000/14.80).

As for gaps beyond the stop, yes this is a risk of trading. But the tighter your stop compared to entry, the more often this will happen. Your distance from 15.00 to 14.80 represents only a drop in price of 1.33%, so I guess this sort of gap is going to hit you every few sessions. What is the reason for your stop being so tight? Have you thought about setting a stop based on price chart structures? Have you thought of setting a stop based on a volatility-based indicator like Average True Range?

Thanks for the response. Your formula is different to those i've come across, for example Tharp's chapter on position sizing also gives the formula of % of account risked / trade risk = position size. He does go on to talk about volatility based stops which as you suggest look like a better option.

let's assume the same $15 share example with a 0.75 stop based on an ATR of 0.25 (3*ATR). 1000 / 0.75 = 1,333 shares. This results in a $19,995 position size. So increasing the stop size, reduces the number of shares purchased which makes sense because a stop size of 1000 would result in the purchase of 1 share.

So this position would still be exposed to overnight gaps, but i suppose less likely with a buffer of 5% in this case. It does still seem risky to have 20% of your account exposed to overnight gaps, or does this sort of thing just come with the territory?

What method are you using to determine position size?

 

[tomorton]

I determine position size by risk. I currently risk 1% of my available account capital per trade: this % has been higher in the past, 2 to 5 often. The size of the position is then driven by the distance to the stop but the stop is always going to be at least 2 x ATR20 from entry to allow for inherent volatility (noise): it could be more using a good TA-based exit point but not less, though I sometimes get out of positions when TA deteriorates even before the initial stop price is reached. I don't ever use a fixed number of pips or points to locate the stop.

 

[J_C_Anderson]

Another point is that sometimes it is better to have smaller position to have possibility to hold on during first hour of each trading session. It happens when the price falls suddenly just after the market opens. In such cases, if there are no news or other events, causing this movement, it is better to hold position and wait for the reversal. Some of the mid-term traders have a rule, prescribing to hold position during the first hour of trading despite any market movement to prevent losses caused by panic selling. That is why it is better to have "comforatble" enough position size.

But in case of huge gap, when trading session opens below you initial entry zone, it is better to close the position and wait.