Struggling to get the right position sizing for your portfolio? We have a perfect solution for you!

Because all the stock doesn’t move up or down likewise, some tend to move more comparatively.  

Position sizing is one of the most important factors in trading or investing, which plays a vital role. But why is it so important? Position sizing has two objectives. The first one is to preserve our capital while the second one is to avoid any catastrophic loss. When it comes to position size, all we think about is how much capital one should allocate to a single stock. However, we would say the position is not only about allocating money but also, about analysing the risk associated with the stock, and based on the risk factor, we will decide the position size.   

Many of us follow this classic approach where we aim for having 15-20 stocks in our portfolio. In the current scenario, so many stocks are breaking out and with strong momentum in the broader market, one tends to have these many numbers of stocks in the portfolio. So, if we take the higher side i.e., 20 stocks in our portfolio, given that we have a capital of Rs 5,00,000, we simply allocate 5 per cent of the total capital to each stock. If all your stocks have similar or identical volatility, it might sound like a perfect plan; however, if this is not the case, your portfolio shall land itself at the risk of volatility. Because all the stock doesn’t move up or down likewise, some tend to move more comparatively.  

So, what’s the solution to this problem? The solution is quite easy; all we need to do is follow the approach of risk parity allocation. We will use the factor called volatility, which will help us to determine how much position needs to be taken in that particular stock. The idea is simple to buy a relatively smaller position in a volatile stock so that each stock has an equal theoretical ability to impact the bottom line of the portfolio. We will use the average true range (ATR), which will give us a fair idea of how much an instrument tends to move on a daily basis.   

We will take 20-period ATR and incorporate it in this formula - total capital * risk factor/ATR.  

Risk factor helps us set a target daily impact for the stock. If you set this number to 0.002, then you’re targeting a daily impact on the portfolio of 0.2 per cent or 20 basis points.  

Let’s see this with an example: 

Suppose the stock of ABC has a 20-period ATR that stands at 42.15. It gives us an idea that this stock has had a daily range of Rs 42.15 for the past 20-days. We would put this in a formula assuming the total capital as Rs 5,00,000 with a risk factor of 0.002 (0.2 per cent).  

So, here we go – 5,00,000*.002/42.15= 24 (rounded off). One can buy 24 shares of ABC and the total amount of Rs 30,480 would be allocated to this stock i.e., 24*1,270. Remember, the risk factor is important; 0.002 can be adjusted according to your risk appetite. So, a risk factor of 0.002 would result in +/-0.2 per cent of your overall portfolio. Further, let us assume that the stock of Tata Metaliks witnessed one ATR move i.e., the stock has witnessed a rise or drop of Rs 42.15; so, it would impact the overall portfolio by 0.2 per cent. Let us see how - Rs 42.15 (one ATR move) * 24 (shares) = Rs 1,011.6. So, one ATR move will have an impact of Rs 1,011.6 on the overall portfolio, which translates to roughly 0.2 per cent.  

Hope this helps you in planning and making better decisions regarding position sizing! Risk parity allocation was coined and designed by Andreas Clenow. We have made an effort to simplify it for you. You are welcome to reach out via comment and clarify your doubts, if any.