Position Sizing – The Perfect Name For Limiting Risk
Position Sizing is THE MOST IMPORTANT ELEMENT IN SUCCESSFUL TRADING. Without it, you will blow up your trading account – guaranteed. You can be using a system with an 85% probability of success and without proper position sizing you can lose a major portion of your trading capital in one bad trade (most likely because you believed you will ALWAYS win). Now string a few losing trades together (see HOW MANY LOSING TRADES CAN I GET IN A ROW) and now you’re in a world of hurt. If at the end of this article, you don’t believe that position sizing is THE MOST IMPORTANT ELEMENT IN SUCCESSFUL TRADING – read it again and again until you do! Seriously, you MUST understand how important it is and use it in all your trading. If you do not follow position sizing, you will never make it in trading.
So What Is Position Sizing?
Position Sizing refers to taking an “Equal Amount of Risk for Each Trade”. Whether the market is going up or down, you need to take an equal amount of risk with each trade. Position Sizing used to be referred to as “Money Management”, but that term was too vague and it didn’t really convey the right message. ”Position Sizing” is the perfect term because you are “Determining the Size of Your Position“ based on a Predetermined Amount of Risk. It is not the total dollar amount of the trade you are concerned with, it’s the amount of risk you take with each trade. No bigger trades on that sure thing, no small trades when you’re not quite that sure. An equal amount of risk all the time.
Why is Position Sizing So Important When Trading A System?
First, you need to understand, there are many many “Trading Systems” out there that can be traded profitably, so the system itself isn’t as important as you think. What is important is the proper execution of the trading system. To properly use any trading system you MUST take an equal amount of risk with each trade. It is fundamental. You can not expect any trading system to possibly perform well if you don’t use standard amount of risk for each trade. It’s no different than placing a standard bet at a roulette table – you never know when your number is going to hit, so the only 2 things you can control are 1) continue to bet on the same number and 2) continue to place the same wager each time. Of course, the odds are with the house on a roulette table, but with a successful trading system, the odds should be in your favor. But you must risk the same amount on each trade to correctly use any Trading System.
What is My Proper Amount of Risk Per Trade?
As a general rule of thumb, and I have seen this number used several times – no more than two percent (2.00%) of your trading account should be risk on any one trade. Many times, 2.00% per trade is too much. I’ve seen 0.50%, 1.00%, 1.50% and 2.00% used, but honestly I haven’t seen anyone recommend more than 2.00% per trade, most of the time with a 3 open trade maximum too. Remember – this is the amount you are risking, not the total amount of the trade. Hopefully, you have already read HOW MANY LOSING TRADES CAN I GET IN A ROW. If you have, you would know it’s possible to lose 16 or more times in a row even with a 50/50 trading system. 16 losses at 2.00% each is a total of 32% – almost one-third of your trading account. That would take a $20,000 account down to $13,600. Trust me, losing one-third of any trading account is some serious damage.
Let’s Do a Very Basic Stock Trading Example
For this example we have a $25,000 account and have decided to use 2.00% as our risk per trade. Thus we calculate that our proper amount of risk per trade is $500.00
We have the following facts:
|Proper Amount of Risk Per Trade For Your Account:||$500.00|
|Share Purchase Price:||$100.00|
|Stop Loss Selling Price:||$95.00|
|Risk Per Share:||$5.00|
As we see above, your proper amount of risk per trade has been calculated at $500.00, meaning you do not want to lose more than $500.00 on any trade. So - based on the facts above – how many shares would you buy? The answer would be 100 shares. 100 shares is your Position Size. The way your trade is set up, you are risking $5.00 per share. Thus 100 shares with $5.00 risk each is a total of $500.00 risk for this trade. You will notice that the $5.00 Risk Per Share is the Stock Purchase Price ($100.00) less the Stop Loss Selling Price ($95.00). It is important to note, your total trade amount is $10,000, but your risk for this same trade is only $500.00. (And you thought 2.00% was such a low number, this trade used $10,000 of your $25,000 account)
The Amount You Risk Per Trade Is The Key
Whatever system you decide to trade will determine what stock you buy, what price you will purchase it at and where to place your stop loss. In order to determine your “Position Size” you only need to determine your Risk Per Trade and you have all the information you need. But don’t get too aggressive with the percentage of your account you risk for each trade. Choose too high of a Risk Percentage and an extended losing streak can still put you out of business. The right amount of risk per trade truly is the key and that means “Position Sizing” really is The Most Important Element In Successful Trading.You Like? Please share! Questions? Put them in the comments below so everyone can learn. Thanks, Gene