Manage Your Investment Portfolio with Position Sizing

light bulbPosition sizing is important to effectively manage a portfolio. It has several objectives:

  • Helps diversify a portfolio
  • Limits the effect of a bad investment
  • Optimizes the positive effect of a successful investment

Traditionally, diversification has meant holding a large number of stocks to protect the portfolio from the adverse effects of one bad stock. A large number of stocks has a smoothing effect. It decreases volatility and tends to average the performance of the portfolio. As an example a mutual fund may have 100 stocks in a portfolio to limit the effect of one stock running into bad times. If the portfolio has the same amount of dollars in each position, the bankruptcy of one stock will have only a 1% effect on the value of the fund. The converse is also true, that a 100% price gain by one of the stocks will only have a 1% effect on the value of the fund.

The married put methodology advocated by RadioActive Trading suggests a different approach to the diversification and position sizing objectives. A typical married put portfolio may only have 5 to 10 stocks in the portfolio. A large number of stocks are not needed to protect the portfolio since each stock is individually insured with the married put. In the RadioActive Trading strategy, it is suggested that the maximum loss in any one stock be limited to less than 1% of the entire portfolio value. Therefore, if one of the holdings goes bankrupt, just like the mutual fund example, the effect on the portfolio is a decline of only 1%. However, if one of the 5 stocks held in a married put portfolio goes up 100% the entire portfolio will increase in value 20% not just 1% as in a mutual fund. The ability to have fewer stocks in a married put portfolio has several beneficial factors:

  • A successful investment can have a big impact on the value of a portfolio
  • It is easier to manage and track 5 to 10 stocks instead of 100
  • Protection from systemic declines is provided, not available in a mutual fund portfolio

This last point needs some additional explanation. A systemic decline is a decline that affects all stocks independent of sector or industry. A decline caused by a recession, financial crisis, and international incident etc. that affects the price of all companies at the same time is defined as a systemic decline. During the 2008 financial crisis most portfolios and funds went down 40 to 50%. But in a married put portfolio no loss can be more than a specified amount, as defined by the put strike price, which is usually a loss of less than 5-9%. During the 2008 decline our married put portfolio was limited to single digit declines. Since each stock is individually insured and limited in risk it tends to be protected from broad systemic declines because of the put insurance.

So we have some basic rules of thumb, which include a loss limit to the portfolio of 1% and a loss limit of 5-9% for each individual stock. But how would this be practically implemented? An example might help illustrate how to implement the positioning sizing process in the context of a married put portfolio. Assume we have $200K of available capital to invest in a married put portfolio. If we invested the entire $200K in one stock that sells for $57 per share, our position might take the following form:

Five Line Setup for a Married Put:mp_pl

Buy Agilent (A) 100 Shares: $56.93
BTO 1 A 17-Jan 60.00 Put: $ 7.80
Total Invested: $64.73
Guaranteed by Put: -$60.00
Total At Risk: $4.73 or (7.3%)

 

Since we want to invest $200K instead of $6,473 we would purchase 3,000 shares, which would equal about $194K into the position and have a maximum loss possible of $14K.

However, there are several problems with this overly simple example. All of the funds could not be deployed and still limit the exposure to 1% or $2K. Since the entire portfolio has only one stock and that one stock is limited to a loss of 7.3% ($14K), we have limited the total loss to the same 7.3% if something were to happen to the Agilent investment. One solution to the problem is to invest in only 400 shares and keep the remaining portfolio in cash, therefore, only about 25% of the portfolio would be invested in stocks and 75% would be in cash.

Another problem with this portfolio is the lack of sector or industry diversification with only one stock represented in the portfolio. This portfolio does limit any loss to 7.3% and total portfolio exposure to 1%, but all of our eggs are in one basket. Our entire investment success depends on one stock.

A better approach is to have half dozen or more stocks in different industries or sectors. If we decide on 8 stocks of equal weight, we would put $200K/8 or about $25K in each stock. To meet the 1% portfolio risk requirement would mean that each stock would be limited to a $2K maximum risk. Therefore, if we invest in $25k increments, the individual stock has to be limited to a $2K or 8% risk (2K/25K) to affect the entire portfolio by less than 1%. A typical portfolio might look like:

#Shares Company Symbol Price/shr. $ Total
300 MasterCard Inc. MA $77.72 $23,316
400 Spirit Airlines SAVE $56.48 $22,592
200 Alexion Pharma. ALXN $176.80 $35,360
200 Michael Kors KORS $98.03 $19,606
800 Silver Wheaton SLW $25.53 $20,424
100 Buffalo Wild Wings BWLD $145.00 $14,500
300 Evercore Partners EVR $55.64 $16,692
300 Facebook FB $68.46 $20,538
$Total = $173,028

 

Each stock is in a different industry and has a greater than double digit growth rate. Some may be considered speculative, but each will be insured to limit losses to 8% to limit risk, even if the stock goes to zero. And if any one stock does go bankrupt the entire portfolio will have a less than 1% loss. Some of the share quantities may have to be pared back to pay for the put insurance, which is not included in the ‘$ Total’ above. A typical 5 line setup for one of the stocks would look like:

Typical Five Line Setup:

Buy Silver Wheaton 800 Shares @ $25.53
BTO 8 SLW 17-Jan 28.00 Put: $ 5.10
Total Invested: $30.63
Guaranteed by Put: -$28.00
Total At Risk: $2.63 or (8.59%)

 

The example is shown per 100 shares; therefore, the total invested in SLW is 800 X $30.63 or $24,504.00. Also note that the risk is a little over 8% and we wanted to keep it less than 8% to meet the total portfolio exposure to 1%. But these numbers are close. Some will be under target and some will be over. These are all guidelines and not numbers that must be exactly met. Stock positions in the portfolio above vary from $14K to $35K, which is close enough to the targeted $25K for investment amounts.

In summary, we have assembled a married put portfolio with the following characteristics:

A total sum of about $200K has been invested
Each stock in the portfolio has double digit growth and is in a different industrial sector
Any one component if lost will result in less than a 1% portfolio loss
If there is a systemic decline of major proportions, each stock is limited to an 8% loss
If one stock doubles the entire portfolio will go up 12%

These are some basic formulas for Position Sizing in a married put portfolio:

At Risk = Total Invested – Put Strike Price
% At Risk = At Risk / Total Invested
Max. Position Size = 1% Available Capital / At Risk
Capital Allocation to each stock < Max. Position Size X Total Invested

 

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