If we start from the premise that risk is the difference between expectation and reality. A trade’s risk depends on your expectations for the trade. If you expect to make money on the trade. Your risk is that you don’t. I don’t know of many people that take a trade for the purposes of losing money. However, because the outcome of any individual trade is random and uncertain. You should at the same time expect that THIS trade could be a loser. As a result you must decide how the market has to look to tell you you’re wrong. When You know how much the market has to go against you to tell you it’s not worth losing more money to find out if THIS is a winning trade. That’s the best place to place your stop loss order. The difference between that point and your entry point is your risk per unit on the trade.
Only after you know you risk per instrument. You can decide how much you want to pay for the potential profits. Doing it the other way around, by deciding with your bet amount before your invalidation point. Leads to being shaken out of a lot profitable trades.You should then buy/sell just enough. That should you stop-loss be hit. You only lose the predetermined amount.
When you divide the risk per instrument on the trade, to the amount you’re willing to lose on the trade you get how much you should be buying. That’s how you calculate your position size
The size of your winnings is going to be directly proportional to the chips you pushed. So the more chips you push the bigger the pay-out. However, if you run out of chips I can’t bet, so you can’t win.
“You can risk any amount on any trade. You can risk 1%, you can risk 2%, you can risk 5%. But the more you risk, the more volatile your equity curve will be” – Ed Seykota.
Long term profitability is also going to be directly proportional to the chips you keep. This is precisely why reducing your risk per trade is important.
So if you have your stop loss order placed in the market. Your broker will get you out at the best price they can. They miss your price by a few cents or rands. But you will not get stung for too much more. Unless your broker offers you guaranteed stops
This means if you place a trade, with a predetermined, pre-accepted risk and correct position sizing. We can call that trade a risk-free trade. Because if you have accepted the risk. It means at the very least you are expecting, a possibility of losing money on the trade.
If you expect to lose money just as strongly as you expect to make money. It means there won’t be a difference between your expectation and reality.