Position sizing is a stock trading concept that concerns how many shares of any one stock a trader should buy. The amount of shares is known as the position, and stock traders who consistently determine the proper size of the position to take on their individual stocks can guarantee long-term financial success even with occasional setbacks. Doing this requires determining how much risk to an overall stock bankroll can be taken on each individual stock. Many traders adhere closely to a formula for position sizing that is tailored to their individual philosophy, the goals for their trading and tolerance for risk.
The stock market is often perceived as being unpredictable, yet many traders still try to outwit its fickle nature by investing large amounts of money on unproven stocks. This puts them at a great risk should those stocks fail and prices drop. By paying closer attention to proven methods of position sizing, these heavier losses can be avoided and the overall portfolio health can be sustained for longer periods of time.
Each strategy for position sizing ultimately depends on the individual trader, but the most common method attempts to mitigate losses by placing a predetermined limit on the risk attached to any one stock. Using this theory, a trader might put just a small percentage of the money he or she has set aside for stocks in a single stock. If that stock gains money, that's fine, but if it loses money or completely fails, the trader won't be completely crippled by its demise.
In this fashion, position sizing puts the burden of stock success less on trying to predict the market and more on money management. Even if several stocks in the portfolio fail, the ones that are doing well can keep the portfolio afloat until more successful stocks are found to atone for the failures. Traders with bigger bankrolls can still afford to buy more shares at higher prices by this theory, but they must be wary not to devote too much capital to one stock.
Many traders couple the notion of position sizing with a tactic known as stop loss to further minimize risks and keep their money flowing to their better-performing stocks. With this method, traders use their original sizing determination to decide how much of one stock to buy, and then the stop loss would be put in place to sell the stock when it drops to a certain point. For example, if a trader decides on a 10 percent stop loss number and then buys one share of a stock that's priced at $100 US Dollars (USD), the trader would sell if the price drops to $90 USD. By using this strategy, the possibility of one poor stock destroying a portfolio is minimized.