The importance of financial management when applied to position size cannot be overemphasized. Wall Street is filled with stories about experienced traders who went broke after long and successful careers because they ignored the oldest and most important rule of money management: Don't take positions that are too big for your financial comfort level.
The urge to make money quickly will always tug at you when you're trading. Fight this urge so you don't have to learn a painful lesson the hard way. Successful trading is first and foremost about survival through financial preservation and consistency, not about
*Sun Tzu, The Art of War. James Clavell, ed. Delacorte Press, 1983.
hitting home-run trades with huge positions. It takes strict discipline and careful preparation to match your positions to your risk profile. The smaller your positions, the easier it will be to maneuver in and out of trades, whether you are adding to a winner, cutting a loss, or taking a profit.
There is a direct correlation between correct position size and higher profitability. Losses are inevitable; but smaller positions produce smaller losses, allowing quicker recovery and less emotional attachment. The key here is emotional attachment. Traders tend to develop a comfort zone for position size, given their financial capacity to take risk. If you trade a position that is too big, then your sense of detachment can be thrown out of whack, adversely effecting your ability to maintain objective discipline.
What causes a trader whose comfort zone is 2,500 shares to buy 10,000 shares? Traders take positions that are too large for a variety of reasons: greed, lack of understanding of money management techniques, faulty trading tactics, the ever-present ego, and unrealistic expectations.
Larger losses are the product of bigger positions. A big loss requires a higher gain in the future to offset it, because of slippage, time, and commissions.
It is much harder for a trader to trade out of a large hole than out of a smaller one. If a trader is down around 6 percent on the month, chances are that the trader's confidence and buying power will remain intact. Successful traders are not afraid of reasonable losses, because they have confidence that they will persevere to make back what they lost and more.
However, if a trader is down 50 percent on the month, it will be a lot harder to regain confidence and stability. Large losses sting, and can cause a trader to be gun-shy in the future.
It becomes increasingly difficult to recapture an unusually large loss when you trade position sizes that are not evenly distributed. In addition to making back the equivalent percentage lost on the bigger position, you'll have to make back the spread and commissions. Many traders who experience a skewed loss resulting from a position that was too big believe that the only way they can make it back is to take a large position again. When this occurs, a trader is oper ating at a psychological disadvantage arising out of desperation. The result is that the risk profile is endangered, and the trader loses the best source of protection.
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