One of the first things I do after waking up in the morning is check the pre-market quotes on my phone.
Usually still in bed, and more often than not, half asleep. Waking up on the west coast at 5:30 AM is still a challenge after living in Massachusetts nearly all my life.
I look at how the major indices moved overnight, where we’re likely to open on the day, and then check on the swing positions I held overnight.
Every once in a while during that last part, my stomach turns and I cringe when I see one of my stocks opening down big from the night before.
If you’re a swing trader, then you know exactly what I’m talking about.
This is the biggest risk we face when holding positions overnight and it’s one that can really cause damage if we don’t take position sizing seriously.
Fortunately, there are steps we can take to reduce the frustration and impact on our accounts when this inevitably occurs.
How to position size when swing trading
Let’s start with a case study of a recent trade of ours.
$ICPT is a stock we got long at the close of the day on Friday, May 15. It was a signal generated on the weekly timeframe, so that’s where we measure and manage risk on the trade.
Here are a few of the reasons for entering:
- Clear close above prior established resistance (300)
- Emerging from a healthy actionable recent base
- Limited overhead supply
Many traders think they know how to position size: simply take the difference of the entry price from a given stop loss and use that to calculate the risk per share.
That’s a good starting place, but it’s severely inefficient by itself.
Your stop loss should be placed at the point which invalidates your trade thesis.
In an ideal world, that is the exact spot you’ll actually exit the trade if it goes against you. Unfortunately, that’s hardly how it really happens.
Stocks can easily:
- Gap below your stop loss while the markets are closed
- Get halted or surface a news event during the day
- Incur slippage or wide spreads (particularly in lower volume issues)
- Move quickly based on macro headlines and/or sector risk
…the list goes on.
So simply position sizing based on an appointed stop loss isn’t enough. You need to incorporate additional risk management constraints to handle some of the above unknown or hidden risks.
Volatility based position sizing
The lower pane on this chart is a standard 14-period average true range indicator. Average true range (ATR) is a measure of volatility which gives us the expected movement of a stock based on its recent trading history.
At the time of our entry in the example above, we can see a 33 point range is what we should expect ICPT to move on a week to week basis.
Knowing this information gives us some context about the type of stock we’re trading and where we may want to place our stop.
If we were thinking of placing a stop loss just 5 or 10 points away from the current market price, then we need to realize that it would have high odds of being triggered, given a 33 point expected weekly trading range.
Even more dangerous, would be the high odds of an opening gap beyond our stop loss and therefore exceeding our anticipated risk.
For this particular trade, while not always the case, our stop loss was in line with the ATR at about 35 points lower from Friday’s entry.
In the cases where our stop loss (invalidation of trade thesis) is tighter than the ATR, we will look to reduce our position size to align with volatility.
Here’s what happened just two days after we entered this trade.
The stock opened with a gap down 15 points from the previous day’s close and proceeded to trend lower for the remainder of the session. Luckily we were able to get out of this position in the middle of the day and not absorb the entire 50 point drop.
Here’s what that weekly chart looked like just two days after we got on board, at the start of the following week.
A 16% down day can do a lot of damage, especially if invested using margin or options. That’s the type of move that’ll leave an aggressive trader broke.
We could have taken a position 7 times larger than we did if we simply chose to use a tight 5 point stop loss.
On paper, it would be equivalent in risk, but really, the 5 point stop loss carries substantially more underlying risk given the natural volatility of this instrument.
Fixed fractional position sizing
Fractional position sizing is a risk metric that sets a cap on the total amount of equity allocated to any one position.
This ensures that you aren’t seduced into taking a trade that could account for 45% of your entire account equity, despite a strategically placed tight stop loss just 2% away.
A simple way to implement this would be to make sure you never have one single position account for more than, say 20%, of your total account equity.
That means if you have a $10,000 trading account with a 20% cap, no single position can exceed more than $2,000 of capital.
It’s easy to keep track of, and it will make sure you aren’t too concentrated and therefore exposed, to any one trade.
Both volatility and fixed fractional position sizing are risk constraints that I account for every single time I place a trade. It’s so important that I created a position size calculator to streamline the process.
The goal is to have a meaningful amount of exposure on, but still be able to sleep easy at night.
A correlation study is a risk management technique that attempts to identify stocks or positions that move very closely to one another.
For example, if you have a full portfolio of stocks that are all in the energy sector, then you clearly have substantial sector risk in the event that something unforeseen happens overnight like crashing oil prices.
Diversifying your portfolio across multiple, uncorrelated, asset classes is one solution to reduce or eliminate this type of risk. Trend followers are perfect examples of traders who consider this exercise essential.
But it’s not for everyone.
For instance, this is not something we choose to do as momentum traders, because it often is our intention to concentrate our positions into only the strongest sectors.
It’s up to you to determine if this is a necessary step in protecting your portfolio without compromising your trading strategy.
How to position size when swing trading
It’s easy to have an exit plan when the market behaves as you expect, but it’s the unknown outcomes that we need to account for and protect against.
By equipping ourselves with multiple layers of position sizing and risk management techniques we can feel confident that our account will be able to survive the inevitable curve ball markets are going to send our way.
To learn more about the position size calculator we use, and to get access, visit this page.
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