2 Reasons Why Proper Position Sizing On Trades Are So Important | Facebook Share Price Collapse
Position Sizing for Trading is one of the three most important skills to master. By assessing the risks of the trade, proper position sizing could help you avoid a costly and very painful loss of your precious hard-earned money. The two main reasons are unexpected collapses of the share price outside of the normal expected volatility of the share/counter and drawdowns.
Unexpected Collapses/ Rises in Share Price Outside Of The Normal
Firstly, unexpected collapses in share price could severely wipe your gains or put you in the red if you are not careful! The recommended risk on any one trade, in my opinion, should be 1-2% of the entire portfolio. That is to say, for a portfolio of $100k, each position should only be $10-20k assuming that the expected volatility within the period in question is 10%. However, sometimes due to unforeseen circumstances, as faced by Facebook’s stock owners, the fall in the share price is so sudden and so large that it falls way out of the normal expectation. In the case of Facebook, it was close to a 20% fall in share price as seen below.
If you had not properly position-sized your account and all of your capital to trade one stock, you would be looking at a 20% loss on your trading account on one single stock. This is going to be very, very painful. Trust me, I had the experience of being an undiversified trader before and I have grown to understand its importance.
Perpetual Terror Of Drawdowns
Secondly, since trading is all about probabilities, it is only normal that there are times where there will be a string of losses a.k.a drawdowns. For example, if you flip a coin 3 times, what are the chances of 3 tails? 12.5%. Is it a high chance? No, it isn’t. But remember if you do it long enough, it is going to happen to you one day. Hence what I would say is to exercise proper position sizing, even when the money is good, and this will avoid having your account drop too much. If you think it’s difficult getting up from where you are, it is even more difficult getting out from a hole you dug to where you want to be in percentage terms.
Of course, position sizing is only one aspect of the game and there are other aspects like having a margin of safety (for investing) as well as ensuring a stock has proper liquidity to ensure your are more successful at investing or trading.To conclude, don’t be greedy when trading and try to maintain at least a 5 stock portfolio to prevent any of these disasters from blowing up your trading account.
Cheers & Good Luck