Position sizing on shorts | Why most traders get this wrong
Adrian Reid explains why risk-based and volatility-based position sizing fail for shorts: they can load up on low-volatility stocks that suddenly squeeze and spike. He recommends equal percent-of-equity sizing instead, keeping each short small enough that even a 2-3× price move only costs a few percent of your account.
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With all the volatility and uncertainty in the world, you're probably thinking about trading on the short side with your stocks. But one of the things a lot of traders do wrong on the short side is their position sizing. So how should you position size on the short side so that you don't get smacked and lose a lot of money when a trade goes bad? The challenge with trading on the short side is that a stock can move infinitely against you, theoretically. You could short sell a stock at $10 and it might open tomorrow at $20 or $30 per share. Now that's unlikely, but it can happen and it does happen occasionally. So given that, how should you position size to make sure that your short side strategies are safe, but also make you money? Well, when we think about position sizing, we usually think about 3 different models. The first and most common is risk-based position sizing, where you size your position based on how far it is to your stop loss. You wanna lose a certain percentage of your account if your stop loss gets hit. The stop loss is often linked to the volatility of the stock. So risk-based position sizing typically gives you bigger positions for low volatility stocks and smaller positions for high volatility stocks. So risk-based position sizing is the first one. The second one is volatility-based position sizing. And that's where you explicitly link the size of your position to the volatility of the stock that you're trading. Now, this sounds like a good idea because high volatility stocks, theoretically higher risk, Low volatility stocks, theoretically lower risk. And the third position sizing model is percent of equity. Percent of equity simply means you take your equity allocation for that system and you divide it up into even chunks. So for example, you might put 5% of equity into each trade for a given system. So which of these three strategies is the best one for using on the short side when you're trading stocks in a bear market? Well, the big challenge that we need to understand is risk. And with the short side strategies, the risk is much higher than it is on the long side. And it's also quite different because when a short squeeze happens, a stock could move from 10 up to 20 or 30 overnight very, very easily. So we wanna make sure that we don't get hurt by those sorts of unexpected rallies when we're short. So here's the problem with both volatility and risk-based position sizing. They link the position size to the current volatility of the stock. And so a stock might be trending down in a relatively low volatility way, and then you size your position. And if you're using risk-based or volatility-based position sizing, you could end up with a quite large position. But the trouble is, what happens if a short squeeze eventuates and the volatility explodes? We then end up with a large position moving against us heavily. And on the short side, that can be really, really dangerous for our accounts. So the best way to protect yourself on the short side is actually not to use risk-based or volatility-based position sizing, to use percent of equity-based position sizing. So if you size all trades equally, what that means is you're not exposing yourself to volatility expansions. If you use risk-based or volatility-based position sizing, you could be taking a large position in a low volatility stock and if volatility explodes and that stock rallies heavily 'cause of a short squeeze, you're gonna get really hurt. You'll have a massive loss on that trade. It's far safer, far more sustainable to have equal position sizing on all trades. If you're trading individual equities on the short side, many small positions drastically reduces your risk because short squeezes happen stock by stock. They don't happen to the whole market. Yeah, the whole market can rally, but the real risk that you wanna protect yourself from on the short side is a stock that you're short exploding upwards. Think GameStop from a couple of years ago. That was the classic short squeeze. And if you had a large position in a stock like that that exploded upwards, you are gonna really get hurt. So equal position sizing based on a percentage of your account. Now, what percentage of your account should you use? Here, what you wanna think about is the maximum loss, the worst case scenario that could happen. And I've seen stocks on the short side double or triple in a very short space of time. So if you think, okay, that could happen to a stock that I'm holding short, obviously it's unlikely, but it can happen. So we need to protect ourselves against it. So if a stock could double or triple in a very short space of time, and then you end up with a very large loss, you wanna make that percentage of equity that you allocate to that trade small enough that that doesn't really hurt you. Let's say you are allocating 10% of your account to an individual short trade. And if that stock doubled overnight, you've got a 10% loss on your account from one position. Obviously that's unacceptable. So if you allocate 5% of your account to one short trade and that doubles overnight moving against you, then you've got a 5% loss in your account. I would argue also unacceptable, too much risk for one trade. When you're trading systematically, there's a couple of layers of protection you've got. I've got here. First of all, you don't trade any one system with your entire account. So each strategy, each system should have a percentage allocation to it. In my portfolio, the maximum allocation is about 20% to any one strategy. Then on the short side, each system holds many tickers simultaneously. So one short system that is allocated, say 10 or 15% of your account might have 20 different holdings. And each of those holdings might be 5% of the capital allocated to that system. So by the time you get all the way down to the individual position level, your trades are really small. And that's perfect for short side equities trading. Because if you get stuck in a short squeeze and the stock really rallies, you don't wanna have a big position. You'd much rather have a small position so that that risk is contained and your portfolio doesn't get hurt. So if you're trading stocks systematically on the short side, You need to allocate a small percentage of your account to each system, and then each system holds many stocks simultaneously so the risk is even more controlled. This is the best way to manage your risk when you're trading stocks on the short side. These techniques are particularly relevant when you're trading systems that hold stocks short for several days in a row. The overnight risk is the real killer here. The other way to contain your short side risk exposure is to exit your short positions at the end of the day so you don't hold overnight risk. Now I still maintain the best way to position size on the short side is equal percent of equity, even if you're only holding intraday. But if you're holding multi-day, then definitely a small percentage of equity per trade is the way you want to size your positions. If you want to learn more about systematic trading, get free resources to help accelerate your journey, go to enlightenedstocktrading.com/free and get your free Trader Acceleration Bundle. And don't forget to subscribe to make sure you don't miss the next video.
