Over the years I have seen many different market environments. From the dot com bubble, the financial crisis, and the 7 year rally to follow. One question I get asked all the time is how to adjust position sizing during the volatile times. There is no doubt that there is a need for adjustment when things get rough and the smartest of traders will tell you to scale back but how? Today we explore some position sizing options for the different types of traders that dare to navigate this volatile market. The day trader - Day traders are attempting to take advantage of small, directional moves in the market throughout the day. How does a day trader know how many shares to buy? Well, the most common approach is risk based. This means that a day trader will base his risk off the entry price and stop price. For example: enter at $50 and have a stop loss at $49.50. This trader has $0.50 of risk. Day traders will set a pre-determined loss amount that they are willing to lose on each trade. In our example we will use $200. With $0.50 of risk this means the day trader will buy 400 shares on this trade. If the trade loses, the max loss is $200. Each trade will have the same loss amount, but the shares will change based on the level of risk. A trade with $0.10 risk means the trader will buy 2000 shares. With this type of approach a trader can limit losses when things get wild yet still have the opportunity to take risk based on the max loss.
Investors - Investors will take a different view since they are not interested in the daily movements of the markets. For the long term investor, capital is the main focus. For most of us we are limited by our capital so we need to use it wisely. Long term investors tend to look at each individual investment as a percentage of their account. This is where it can get tricky. If you find that you are active and like to have a vast portfolio you will consider using a smaller portion of your account for each trade. Also many long term investors like to start a position and add to it over time. You may consider starting a position with1% of your long term assets and add up to 3 or 4% over time. Again, this depends on your level of activity.
Short term traders (Swing Traders) - Swing traders tend to be very active have a few days to a few week time frame. A swing trader will be slightly more aggressive than long term investors. This is due to the faster turnaround of individual trades. In my experience, swing traders will use around 3-10% of available funds for their trades. Most swing traders will not add to existing positions, rather they will exit in pieces. This also helps to free up funds for new trades. Stop losses are generally based on a percentage move in the stock. Ex. An 8% drop in stock price causes an exit. During highly volatile times the swing trader will likely enter half and half. This will allow them more flexibility should there be a sharper than expected move.