For those unfamiliar with the term position sizing, it is just determining how many shares of a stock you should buy or short. It is based on your account size and your risk tolerance. Although it is a pretty simple concept, it is one of the most important factors that should be considered prior to placing a trade. The reason for using position sizing is that it is one of the few things that you can control about your trade and is an important tool in preventing you from blowing up your account. Unfortunately, most traders either donít even think about position sizing or if they do, they don't approach it scientifically. Instead, they either buy a standard amount of shares, like they always buy 500 shares, or they just go with their gut, like they see a really good set up so they buy more shares than they normally do.
Although a great deal of the approach to trading is an art, position sizing is one of the few tools that can be approached from a scientific perspective. It is a function of your maximum allowable loss, your stop on the specific trade you are looking to enter and your account size. For example, letís use an account of $100,000 with a maximum allowable loss per position of 2% (i.e. $2,000). So if you are looking to enter a stock trading at $50 and your stop loss is going to be placed at $48 (a $2 stop) then the maximum number of shares you can buy is 1,000 (i.e. $2,000 divided by $2).
Position sizing should be used by EVERYONE on EVERY trade. If you want to make money in the markets, you have to learn to control your losses. Position sizing is a very important tool that can be used to achieve that objective. I cannot stress the importance of using position sizing enough. If you want to make money in the markets, you MUST use the appropriate position sizing.