Overview
Trade sizing is the typical method of day traders and others who do not use quantitative methods to do portfolio construction. Traders will typically determine buy or sell signals for assets, then allocate funds based on whether the asset is a buy or not. Trade sizes are typically determined to be a certain percentage of available capital (typically around 2%), and the trader will usually put stops on the order.
It is common that any buy will be assigned the same (pre-defined) percentage of capital, however, at times traders will define a range of exposures.
Setting Exposure Limits
Exposures are calculated to maximize the probability of achieving two objectives
- Portfolio Risk not to exceed a certain level - sometimes the portfolio risk constraints are just a limit on the percentage of capital allocated to any given asset or trade. Other times, more sophisticated quant models are used.
- Achieving a Target Return - this is typically done by estimating an average return from past history based on the trade signals employed. Then the number of shares is scaled to target a given return, but not beyond the risk limits defined. For example, the trade may be placed with up to 2% of capital, but not more.
These two objectives are in opposition to each other. If the risk constraint is set too low, the probability of hitting a high return target becomes small.