Position sizing techniques: Estimating Equity Capital for Active Traders

Defining Equity Capital

The last chapter gave an overview of position sizing, showing why it is important to include in any trading strategy. We will now look further into how to implement effective position sizing. This involves determining the amount of your equity capital that needs to be exposed for a particular trade.

A small recap on position sizing

Position sizing is all about working out how much capital to dedicate to a particular trade with the capital you have available. The popular 5% rule is widely used, which means that no more than 5% of the trading capital can be placed on one trade. For instance, if your capital is Rs. 100,000/-, then no more than Rs.5000/- may be risked in any single deal.

In this scenario, the trade has an exposure of 5000 units, while the equity capital amounts to 10000 units. You have made the decision to invest 5000 units per trade, guided by a position sizing rule or strategy.

It’s clear there is no one-size-fits-all approach for position sizing; you need to try various methods and determine which works best for you. Later on, I’ll cover some techniques to help give you ideas.

No matter what position sizing strategy you adopt, eventually it will necessitate estimating your equity capital. Therefore, let’s discuss the process of gauging equity capital before we look into the various position sizing approaches.

What do I mean by equity capital?

Equity capital is essentially the sum of funds in your trading account which you use to decide how much money to invest in a trade. This might seem straightforward to you right now. But let me explain why it’s more complicated than that.

Suppose you have Rs.500,000 to invest in the market and employ a strict position sizing system, limiting each transaction to 10% of your capital. With this in mind, a single entry should be no more than Rs.50,000.

What is your equity capiital for the next tradE? 

Is it Rs.450,000?

Is it still Rs.500,000 considering the fact 50K is deployed in a trade?

Should it be 450,000 plus 50K ± the P&L from the trade that exists in the market?

Due to the sheer amount of potential outcomes and scenarios, calculating equity for a trade is not easy. It is therefore vital that we get our calculations precisely right when determining equity capital before exploring position sizing principles.

– Estimating  Equity Capital

Let us refer to Van Tharp and examine the methods he utilizes to determine equity capital. These are deemed some of the more reliable ones compared to many others. He elaborates on three distinct models.

– Core Equity model

– Total Equity model

– Reduced total equity model

To follow the core equity model, when you make a trade, deduct the capital allocated to that trade from your existing equity capital. For instance, if your equity capital is Rs.50,000 and you use the 10% position sizing formula, the first trade will be exposed to Rs.5000 of your capital, reducing your equity to Rs.45000. Examples of this can be seen in the table below:

So, the initial capital of Rs.50,000 is reduced to Rs.45,000 when 10% or Rs.5,000 is used in the first trade. To use the Core Equity Model, you must deduct the capital used in a trade and then recalculate so that this lesser amount is your available equity for subsequent trades.

For the 2nd trade, 10% of the total equity, Rs.4500/- is deployed. This reduces the core equity to Rs.40,500/-, which is now available for the 3rd trade.

For the third trade, capital exposure is Rs.4050 and core equity is Rs.36,450/-. Understanding what I mean should be evident.

This equity estimation model is slightly conservative, as you cut down the capital allocation with an increase in opportunities. Although the fifth trade may be a major success, it could also be your worst nightmare compared to the others.

I appreciate this model due to its straightforwardness. Investing the capital, then allowing it to grow is a process that requires minimal attention.

The Total equity model takes into account each and every position in the market along with its associated P&L and cash balance to calculate the equity. For illustration, I will provide an example to make this more understandable.

Free cash available – Rs.50,000

The margin blocked for Trade 1 is Rs.75,000.

P&L on Trade 2 = – Rs.500

The amount of margin blocked for Trade 2 is Rs.115,000.

The P&L on Trade 2 is a gain of Rs.7000.

Margin Money Blocked for Trade 3 amounts to Rs.55,000.

P&L on Trade 2 = – Rs.2,000

Total Equity = 50000 + 7000 + 2000 +115000+7500+55000-4000

= Rs.300,000/-

It’s clear then that the Total Equity Model looks at free cash, margins locked and the P&L per position. My strategy for sizing positions would thus be: 10% exposure to a new position of Rs.30,000/-. But if my account balance doesn’t allow it, I can’t start a new trade – I’d need to close one of my existing positions first in order to open the new one.

Taking the live position’s P&L into consideration for gauging equity makes this model rather risky, and I’m not personally a great admirer of it. It’s somewhat like forecasting before the chickens have hatched.

I particularly favour the ‘Reduced Total Equity Model’ to calculate equity.

This model unites the strongest points of the core equity and total equity models. It minimises capital allocation to an individual trade (as per the core equity model) while including the total profit and loss of a position that has already been established (in the same way as with the total equity model). Nevertheless, this P&L sum is only based on secured gains.

To help you comprehend this better, I will use an example. Let’s assume that I possess a capital of Rs.500,000/-, and my position sizing strategy only permits me to invest no more than 20%, or Rs.100,000/- per trade.

After examining the chart of ACC, I chose to buy ACC futures at 1800 with a margin of about Rs.90,000/—which matches my position sizing limit of Rs.100,000/-.

I’m now in a position and awaiting the market to shift. Utilizing the reduced total equity model, my access to capital for the second trade is –

20%*( 500,000 – 90,000)

= Or about 20% of Rs.410,000/-

= Rs. 82,000/-

Taking into account the present circumstances, the exposure capital has thus gone down from Rs.100,000 to Rs.82,000/-. This follows the same principle as that of the core equity capital model.

Assuming ACC rises 25 points to 1850, given its lot size of 400, I can look forward to a paper profit of –

400*50

= Rs.20,000/-

A trailing stop loss should be implemented, and at least 25 points (roughly Rs.10,000) out of the 50 point move can then be secured.

For the extended ACC position at 1800, a stop loss should be placed at 1825. This will guarantee a profit of Rs. 10,000/-.

I will now incorporate the locked-in profits into my total equity, raising it to –

410,000 +10,000

=420,000/-

This means my new exposure capital will form 20% of the equity in total.

=20% * 420000

= Rs.84,000/-

It is evident that exposure capital has now risen by an extra 2000/-.

I’m quite fond of the reduced total equity approach to calculating the capital available to size positions. Not only does this technique lead one to follow better stop loss principles, but I believe it is a beneficial practice.