Many successful traders regard position sizing as the holy grail of risk management, ultimately of trading successfully. Essentially it’s the quantity of the chips you want to bet on a trade, and is related or at least should be related to how much you want to risk on that trade.
A trade at least in the beginning has 4 primary components
- Direction
- Entry
- Exit (stop loss and Target)
- Position size
Direction, entry, and exit could be determined either through technical analysis or fundamental analysis. When you enter into a trade for whatever reason, you have to determine the size of your bet/trade. While many methods exist I will share the method that I use to size my bets.
A trade has 5 possible outcome
- Small winner
- Small loser
- Big winner
- Big loser
- Breakeven
Depending on your position sizing you will get one of the above when exiting a trade. How big is big or how small is small, is a subjective call from by the trader.
Your job as a trader is to limit those outcomes to just 4 to exclude the big losers. The big losers not only damages your account balance but your confidence as well.
Before getting into position sizing its important to understand the importance of a stop loss. A predetermined level in which you will exit the trade should the trade not work out. We use this level to calculate our bet size. To calculate your bet size, you have to divide the maximum you willing to lose on a trade by the risk per share.
Here how it works
Say you’re about to enter into a trade, based on technical or fundamental analysis and you’ve determined your stop loss level as well and your target. For the purposes of this example, I will assume the following and will not factor in slippage and commission
Account balance: R10 000
Max risk per trade: 2%
Long example 1
Entry: R10
Stop loss: R8
Risk: R10 – R8 = R2 per share
Target: R14
Potential reward: R14 – R10 = R4
Risk Reward ratio: R4/R2 = 2:1
Maximum risk: R10 000 * 2% = R200
Position size: R200 / R2 = 100 shares
Long example 2
Entry: R10
Stop loss: R7
Risk: R10 – R7 = R3 per share
Target: R16
Potential reward: R16 – R10 = R6
Risk Reward ratio: R6/R3 = 2:1
Maximum risk: R10 000 * 2% = R200
Position size: R200 / R3 = 66 or round off to 67 shares
Now let’s look at short examples
Short example 1
Entry: R10
Stop loss: R12
Risk: R12 – R10 = R2 per share
Target: R6
Potential reward: R10 – R6 = R4
Risk Reward ratio: R4/R2 = 2:1
Maximum risk: R10 000 * 2% = R200
Position size: R200 / R2 = 100
So it doesn’t matter how wide or tight your stop-loss is, you’ll always risk the same % of your account equity on each trade. This % is also subjective to the trader. This % will to some large extent determine the length of your stay in the markets. The smaller it is the longer your stay will be.
The goal of a successful trader is first the long term capital preservation, It keeps them in the game for longer. You can only win a game if you’re in the game. Correct position sizing can ensure your long term survival.