One of the biggest problems for novice investors and traders is position sizing. There is little in the way of concrete rules on how big a position should be. In our experience every trader comes to this important metric in their own way. Usually in the form of hard earned experience.
The problem of position sizing is made even worse when the actual size of the position is misunderstood. Adam Warner at the Daily Options Report describes how investors mistakenly equate the dollar premium invested with position size (delta). Any one familiar with options pricing can see the error in the proposition, but for those just starting out the lesson learned can be quite painful.
Brett Steenbarger at TraderFeed makes this point as well as a part of the list – “Top Ten Reasons Traders Lose Their Discipline.” Number 3 on the list:
3) Trading positions that are excessive for the account size, created exaggerated P/L swings and emotional reactions;
Position sizing is inextricably linked with portfolio size and risk tolerance. Trading in sizes that are too large (or too small) can quickly frustrate an emerging trader.
The point is also driven home by Joe Weisenthal at DealBreaker.com. Another form of error in position sizing comes via confusing stock price with value. The question of “unit bias” in regards to investing is well elucidated by Weisenthal in this (lengthier than usual) excerpt:
If there’s one kind of column that is worthy of derision above all others, it’s the “cheap stocks for under $10 (or $5)” piece (Natural habitat: thestreet.com). There’s certainly a special hell for those promoting the idea that stocks with nominally low prices somehow classify as cheap. But these columns are likely to persist as long the individual retail investor is a) a sucker and b) subject to the unit bias. Basically, people are likely to see their consumption change based on the size of the units involved. For example, a bowl of free M&Ms with a teaspoon for serving will prompt less per/person eating than when a tablespoon is placed in the bowl. Generally, the larger the implied minimum quantity, the more people will eat. Now in stocks it’s the other way around. Eating more is good; paying more for stocks is bad. So when people get the chance to buy a cheap stock, time to fire up the Powertrader account.
In short investors/traders need to be acutely aware of the actual position size they are taking. Whether it is deep-in-the-money options or low-priced stocks a portfolio’s profitability is linked with actual position size. In short, know what you own.