The size of your position is an essential part of risk management. Knowing the maximum amount you are willing to lose will affect how you respond to inevitable fluctuations in price movement.
Assessing your risk appetite will limit how much you can afford to invest and protect you from over-leveraging. It involves asking the right questions about yourself, your financial situation and market conditions.
Check your financial position
How much do you have to invest? Your investment amount should be separate from any money put into the market for living expenses. If certain investments are off-limits and out of bounds, it will not leave you with many options if markets move against you.
And don’t forget about taxes! Tax authorities may consider trades gambling, therefore incurring capital gains tax or stamp duty on your transaction costs. It would need to be taken into account when determining position size. Also, remember that margin trading is subject to a higher taxation standard than other forms of investing due to the increased risk involved in these types of transactions.
Know your reasons for your position as part of your risk strategy?
Why are you investing? What motivates your investment? Some people invest for appreciation; others invest for income. You should base your position size on what you want to accomplish or achieve with your investments.
The time frame of the trade as part of the risk strategy also matters
Open-ended trades will require more prominent positions than those held overnight or until maturity. A long term position needs a different mindset from one set to close out after a day or two.
If you think about going long on security, consider how much you expect its price to rise over a year and multiply it by 10 to see how prominent your position could be if you scaled in during periods where the price was “on-sale”.
Should you go long or short?
The outlook for security as part of a risk strategy determines if you should go long or short. The investors at Saxo Hong Kong are experts at this.
The return on an asset doesn’t always mean you should buy it. For example, an expected 10% return might not be enough to warrant a long position if there is a high chance that market prices will fall in the future. However, investing in options could provide that same level of expected growth while keeping your capital protection by providing income through premiums gained when writing covered calls or selling naked puts.
How liquid is the asset?
Determining how many buyers are available at what price level can help decide your maximum exposure and how quickly you may need to close any open positions due to price fluctuations. If there are not enough buyers available, you may fill your orders at a much lower price than you had anticipated.
Where is the price relative to its historical highs and lows?
Assessing where a purchase was priced in the past will determine whether it is cheap or expensive compared to previous movements. The volatility of an instrument also plays a part – liquid instruments tend to have higher daily fluctuations than less liquid because more market participants are chasing after them and willing to buy and sell at different prices.
It can work to your advantage if you expect price volatility to decrease as markets mature and liquidity becomes more significant over time as well as due to regulations enacted by governing bodies such as the FCA
What other instruments do you have experience with?
Your own experience and knowledge of other instruments will help determine whether a particular position is “too big”. Make sure the asset you are thinking about trading isn’t too different from what you already know and understand to avoid taking on more risk than is prudent.
For instance, some people who hold units in an ETF may wish to take a short position on Bitcoin as part of their risk management strategy. They would specifically need to consider how Bitcoin’s features such as 24hr trading volumes, market volatility and capped supply put it at a distinct advantage that makes it easier to realise gains over time.