How to Cut Risk and Maximize Profits with Position Sizing

This money-making tip comes from our Chief Investment Strategist, Keith Fitz-Gerald:

The only thing standing between your portfolio and catastrophic loss is your own caution and proper risk management. Risk management may not be the most exciting part of investing. But it's the most important.

A risk-management tool called "position sizing" stands out above all others as the most powerful, and not just for cutting risk, but for boosting profits, too.

The concept is simple. It's about controlling the amount of money you place in each trade.

Here are three different methods for sizing your positions, from simple to sophisticated:

1. The 2% Rule: Make sure you have no more than 2% of your risk capital at stake in any single recommendation. The advantages to this model are simplicity and the fact that you can use it even with small sums of money. The disadvantages are that there's no accommodation for different types of investments, and small accounts can get overexposed if you're not careful.

2. The Percent Risk Model: This method serves as a great indicator for the appropriate amount of risk to take on, whether you're a seasoned investor or someone who's just getting started. Here's the formula:

Dollar Risk Size / (Buy Price - Stop Price)

Let's say you want to buy a $20 stock with an $18 stop loss, and the maximum amount you've resolved to risk is $2,000. The formula suggests you buy 1,000 shares. This model is great for long-term investors and trend followers because it regards the risks associated with each trade equally.

3. Adjusting Risk According to Volatility: This gets a little more complicated, but here's the formula:

Position Size = (CE * %PE) / SV

CE is the current portfolio size. %PE is the percentage of portfolio equity that a trader is prepared to risk per trade. SV is volatility over some predetermined range like the preceding 10 trading days, for instance. If a trader with a $100,000 portfolio is prepared to risk 2% of total equity and the volatility is $1.50 over the past 10 days, the result is 1,333 shares initially. However, as volatility drops, a trader using this model would add to positions. As volatility rises, he would cut back. You can't just set it and forget it with this method, but it provides a flexible balance between opportunity and the risk needed to capture it.

Understanding position sizing will put you miles ahead of other investors who spend all their time wondering what to buy while ignoring the critical question of how much to buy.

For more information on the different methods for sizing your positions, go here: This One Risk Management Tool Made the Difference Between Bankruptcy and $13 Million