Overconfidence, Position Sizing, and Hot Stoves

Today I learned an important lesson about position sizing.

Basically, the lesson is to always be consistent in your position sizing, no matter how confident you are in your setup.

In other words, don't get cocky and use a bigger position size than normal just because you're confident in a setup.

Today I shorted TRGT at an average of 7.01, using my typical position size. It was exactly the type of short setup I like.....huge jump in only a few days (it was over 200% of its lows) and wayyyyy, way outside the upper bollinger band. Trading volume had dropped off tremendously, and it was trading in a channel through the day, but showing lower highs and less volume as the day went on. Plus, it was way up on the positive results of a Phase II study....in other words, no fundamental change in the company itself, and obviously the drug is still a long ways from being on the market. Basically, hype, momentum traders, and the fact this was a low float stock is what pushed it up so far, so fast.

About 11 AM PST, it looked like TRGT was beginning to fade, and it fell under 7. This is where I got overconfident. I added to my position size. In fact, I tripled it, bringing my average cost basis to 6.97. For a little while, it looked like I was going to be right. TRGT fell below 6.90. I was looking for it to at least fall to the 6.50ish support level.

TRGT came back up to around 7. I figured it was just a bounce and I held.

Suddenly, TRGT had a huge pop to 7.20ish within 2 minutes. My mental stop was 7.18. I held, given that it had popped similarly throughout the day and came right back down. But it held the 7.10-7.18ish level. For a little bit it looked like it might come back down, but then it squeezed higher. I ended up getting out at 7.25, and completely wiped out my day's profits in one trade and broke even for the day.

I don't mind taking the loss on the trade. My mistake was adding to my position and increasing it dramatically. This was a particular mistake given that TRGT was a low float stock and could squeeze easily. Rather than taking a small loss and finishing the day with a profit, I took a large loss simply because my position size was too large compared to my typical position sizes.

For a while now I've been using Van Tharp's methods for position sizing with success. He has determined that an optimal position size is to risk no more than 1% of your capital in any one trade. So, if you have $10K of capital, you shouldn't risk more than $100 per trade. That doesn't mean you only put $100 into a trade. It means that, if a trade hits your stop loss, you'll lose around $100.

I broke this rule and tripled my risk, and paid the price.

No matter how sure you are of a setup, remember that the market doesn't care. I thought the risk of a squeeze for TRGT was low, and the market didn't care. You shouldn't change your risk based on how confident you are in a setup. While there's certainly nothing wrong with risking less than you typically would in certain situations (like stocks with big spreads), you should never risk more than you typically would.

As I mentioned in a previous post, I'm reading Fooled by Randomness right now. Nassim Taleb talks about how no matter how much you tell human beings not to touch a hot stove because they'll get burned, they usually will ignore such warnings and have to learn by experience. This was a case for me of learning by experience despite the fact I knew about appropriate position sizing. Of course, I've found with trading that sometimes you have to touch that hot stove 10 times before you finally learn not to touch it.