What you will learn
- Calculate position size from a loss budget and an exit level.
- Show how leverage magnifies gains, losses and margin pressure.
Sizing from a loss budget
Position sizing decides how much to hold so an adverse move costs an acceptable amount. A common framework limits the loss on each position to a small share of the portfolio and derives size from the distance between entry and exit levels.
Units equal the loss budget divided by the loss per unit. This ties size to risk rather than to confidence. Exit orders are not guaranteed, because gaps and slippage can fill beyond the stated level.
Scaling by volatility
Volatility-based sizing holds less of assets whose prices swing more, so each position contributes similar risk. If one asset's volatility is three times another's, equal risk contributions call for about one third of the weight.
This ignores correlation, so positions that move together still concentrate risk even when each is sized sensibly. Volatility is not constant either, so sizes need revisiting as it changes.
Leverage amplifies everything
Leverage is total exposure divided by equity. At 4 times leverage a 10% fall costs 40% of equity and a 25% fall erases it. Borrowing also adds financing costs that accrue whether or not the position gains.
Margin rules can force positions closed when equity drops, often during the same turbulence that caused the losses. Lower leverage buys time to survive adverse periods; higher leverage shortens it.
Worked example: Sizing from an exit distance
A 200,000 portfolio allows a loss of 1%, or 2,000, on one position. A fictional share trades at 40.00 with an exit level at 37.50, a 2.50 loss per share. Size is 2,000 ÷ 2.50 = 800 shares, worth 32,000, or 16% of the portfolio. If the share gaps to 36.00 and fills there, the loss is 800 × 4.00 = 3,200, or 1.6%.
Check your understanding
A portfolio has 50,000 of equity and 200,000 of exposure. What is the leverage, what equity loss follows a 10% fall in the exposure, and what fall erases the equity before financing costs?
Show answer and explanation
Leverage is 200,000 ÷ 50,000 = 4 times. A 10% fall costs 20,000, which is 40% of equity. A fall of 1 ÷ 4 = 25% would erase equity. Margin requirements would usually force action sooner, so the practical limit is tighter.