Why Position Sizing is Considered More Important Than Stop Losses in Risk Management

Fact checked by
Mike Christensen, CFOA
July 22, 2024
Position sizing is more important than stop losses in risk management because it prevents catastrophic losses, especially during volatile markets. Proper sizing helps traders avoid deep drawdowns, making it easier to recover from losses.

Position sizing is often viewed as more critical than stop losses for long-term success in trading. While stop losses are essential for managing risk, position sizing helps traders avoid catastrophic losses and stay in the game longer, even when volatility unexpectedly increases.

Why Position Sizing Matters More

Stop losses are typically used to exit a trade quickly when it moves against you. However, they can be ineffective if:

Market volatility spikes, hitting tight stop losses repeatedly.

Execution errors occur, leaving the trader exposed to larger losses than expected.

Position sizing, on the other hand, ensures that even if a trade goes completely wrong, the loss will only represent a manageable portion of your account. This helps you survive extreme market events, allowing for more controlled risk over the long term.

Example of Position Sizing’s Power

If you risk 1% of your account per trade, even if a stop loss fails to trigger or the trade goes completely against you, the maximum loss won’t wipe out your account. This is especially important when dealing with unexpected volatility spikes or tail events.

Drawdowns and Recovery

The deeper the drawdown, the harder it is to recover:

• A 10% drawdown requires an 11% return to break even.

• A 50% drawdown requires a 100% return to recover.

By using proper position sizing, traders can avoid large drawdowns, making it easier to recover from losses and stay profitable in the long run.

Conclusion

While stop losses are essential, position sizing plays a more important role in preventing significant drawdowns and maintaining long-term profitability. By controlling position size, traders ensure they survive adverse market conditions, reducing the need for large recoveries after losses.

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