Why Position Sizing Matters

Position sizing is the mathematical process of determining exactly how many shares or contracts to trade based on your account size and risk tolerance. It's often called "the most important aspect of trading" because it determines whether a losing streak destroys your account or merely sets you back temporarily.

Two traders with identical strategies can have vastly different results based solely on how they size their positions. Proper position sizing ensures that you stay in the game long enough for your edge to play out.

The Percent Risk Model

The most common approach is to risk a fixed percentage of your account on each trade. The CFA Institute recommends no more than 1-2% per trade for most traders.

Position Size Formula

Position Size = (Account Size × Risk %) / Risk Per Share

Example: $50,000 account, 2% risk ($1,000), stock at $20 with stop-loss at $18 (risk = $2/share)
Position Size = $1,000 / $2 = 500 shares

The Kelly Criterion

The Kelly Criterion is a mathematical formula that calculates the optimal percentage of capital to risk for maximum long-term growth, given your win rate and reward-to-risk ratio.

Kelly Criterion Formula
Kelly % = W - (L / R)

Where:
W = Win rate (as decimal, e.g., 0.55 for 55%)
L = Loss rate (1 - W)
R = Reward/Risk ratio (average win / average loss)

Example:
Win rate: 55% (W = 0.55, L = 0.45)
Avg win: $200, Avg loss: $100 (R = 2.0)
Kelly % = 0.55 - (0.45 / 2.0) = 0.55 - 0.225 = 32.5%

The Fractional Kelly Approach

Full Kelly maximizes growth but creates extreme volatility and drawdowns. Most professional traders use Half Kelly or Quarter Kelly:

  • Full Kelly: Maximum growth, but 30-40% drawdowns are common
  • Half Kelly: ~75% of optimal growth with ~50% less drawdown
  • Quarter Kelly: More conservative, suitable for most traders
Professional Recommendation

While Full Kelly suggests 40% on a trade, a string of three consecutive losses would wipe out over 78% of the account. Use 0.10x-0.15x of Kelly-optimal sizing as a practical rule.

Drawdown and Risk Tolerance

Your position sizing should be based on the maximum drawdown you can psychologically and financially tolerate:

Risk Per Trade Max Drawdown (10 losses) Suitable For
0.5% ~5% Very conservative traders
1% ~10% Most retail traders
2% ~18% Experienced traders
5% ~40% Aggressive (not recommended)