Saturday, October 24, 2009

The Psychology of Position Sizing

To kick off this topic, let's go back to the post on how drama creates trauma: by sizing positions much larger than our norms, we create large swings in dollar P/L, which often translate into large emotional swings--and subsequent emotional damage.

If there is anything more frustrating than being wrong in the markets, it's being right--and then not participating in the actual moves.

Often this occurs because, in our drive to maximize gains, we can size positions so aggressively that we become unable to take normal heat when the market temporarily moves against us.

A great example occurred for me during Friday's trade. I was short from late Thursday and watched the market move against me overnight and then bounce sharply against me on the housing numbers Friday morning. Because I sized the position moderately, I could stand the heat, because I saw that we were not breaking above the multiday trading range. And if we had broken above that range, the loss wouldn't have ruined my week.

Had I been sized much larger, it's much more likely that I would have been spooked out of a good trade. When I'm sized reasonably, I'm willing to risk 5-10 ES points to make 10-20 or more. Sized to the max, I start to translate those 5-10 points into dollar terms--and that leads to scared, reactive decisions.

The purpose of the profit targets that I publish each morning before the market open via Twitter (subscribe here) is to provide a gauge for likely market movement. When I see strong selling pressure (negative NYSE TICK; large volume hitting bids in Market Delta) on enhanced relative volume, I formulate the view that we're likely to hit the S3 price level. My job at that point is to simply sit in the trade, make sure that the market dynamics are not significantly changing, and formulate an exit based on market behavior once my levels are hit.

If I'm processing how much I'm losing (on paper) on countertrend bounces, I'll never sit through the the pain of the gain and earn the reward that justifies my risk.

The ability to sit through a trade is greatly underappreciated. We tend to focus on entries, exits, and the next trade, and the next one--constantly looking for things to do. Sometimes, however, the most profitable strategy is to do nothing and simply let your trades work out. That requires a moderation of sizing/risk--and a kind of inner peace and satisfaction with the positions you have on and the bets you've made.