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The Importance of Position Sizing

What is the most important risk management tool? It's not stop loss. It's position sizing. We discussed the importance of position sizing many times. We discussed why we don't recommend putting more than 10% of your account into a single trade. But the markets provide us with more evidence every single time.

Our members are familiar with our new "risk free" trade that we introduced a few weeks ago. This is a very low risk and high probability trade, and one of the members posted the following question:


"I am trying to understand more in terms of how many contracts I should buy if I have let's say $10K in my trading account? If the margin is on average $900 per contract can I safely trade like 10 contracts with a $10K account?"

The answer is a big NO!!!!!!!!!!!!!!! You never put your whole account into one trade.

Our last week trade provided a good reminder why you should never do it.

I woke up on Friday with no internet connection - turned out to be a massive Canada wide outage that affected millions of Canadians. A complete network failure - no Wi-Fi, mobile network or phones.

While the official trade was close early morning on Friday for a modest loss, I could not close the QQQ combo position on Friday.

If I was assigned the short options, it would be not that bad - I would be short 200 shares of QQQ and long 4 calls. In terms of delta, it would be not too directional, and I would just close the shares and the calls at the same time.

However, IB algorithm is different from other brokers. This is how it works:


"Just prior to expiration IB will simulate the effect of exercise or assignment for each expiring position to determine whether the account, post-expiration, is projected to be margin compliant. IB may liquidate positions in the account to resolve the projected margin deficiency for Accounts which do not have sufficient equity on hand prior to exercise."

This is exactly what happened. Around 15:30, the algorithm determined that assignment of the short calls will cause margin deficiency, and according to their policy, they liquidate most of the short calls (just enough to prevent margin deficiency). The rest of the short calls were assigned, so I was left short QQQ shares and long significant amount of calls. 

According to Murphy's laws, the markets gapped down today, and I was forced to close the calls for a significant loss.

As one of our members mentioned, this is a very useful reminder of how strange events, that 1-in-a-10,000 chance of something happening can result in unexpected losses. What are the chances of there being a Canada-wide outage? What are the chances that it will happen on Friday and last the whole day? 

This is why position sizing is so important. No matter how safe and low risk the trade looks, unexpected can always happen. If you keep your position sizing under control, you can still recover.

This is also a good reminder of how conservative our performance reporting is. If we close (for example) 4 trades per month, each for 5% gain, what gain would we report? Many other services would report a 20% gain - but that means they put the whole account into a single trade. We would report a 2% gain because each trade represents 10% allocation.

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