How do I select the size of each trade?
Hello Experts – should I always trade the same size or different sized amounts, and should the size of the trade depend on the risk? Can you give me ideas of how other traders deal with this. Your help is appreciated. Clive
Dear Clive and readers,
Your question touches on a concept that is one of the most important aspects of developing a successful strategy and maintaining a professional approach to trading. Position sizing is the key to managing your risk. It represents a structured approach and controls the emotional elements of selecting the size of each trade. Over time, a number of approaches have been developed enabling traders to incorporate simple calculation methods to set position sizes to match their individual risk thresholds.
The approach that we will consider in this piece is known as the ‘fixed percentage risk method’. This method uses a calculation that is based on risking the same percentage of a traders capital on each trade.
Some “risk seeking” traders may argue you should risk more or “take larger positions” on the trades you are very confident in and less on the ones that you aren’t. However professionals or those who are more risk averse will generally focus on controlling potential losses.
Professionals operate according to a plan and strategy, they understand there is no certainty to market related outcomes and in becoming successful traders they recognise quickly that losing trades are an inevitable part of trading. As there are many factors influencing share prices at any given point in time and it is extremely difficult to predict the outcome of a trade with any real certainty.
Professional traders aspire to increase the number of profitable trades and minimise the losses and number of losing trades.
When looking at initiating the “fixed percentage risk method” to set your own position sizing you will need to establish three key pieces of information. These are; (i) the entry price of the trade, (ii) your exit price or stop loss level and (iii) your total available capital.
Let’s take a look at an example of a trade in XYZ CFD. In order to determine our position size for the trade we must evaluate three pieces of information; the entry price, stop price and available capital.
The final piece of information needed is the amount you are willing to put at risk as a percentage of your capital, for this example we are going to risk 2 % on each trade.
Capital at Risk: $10,000 x 2%
Should XYZ’s price decline by $0.25 we will take a loss on the trade and close out the position. This is called the share price risk of the trade.
To calculate Share price risk we subtract the entry price from the stop loss price
Share price Risk: $5.00 - $4.75
To calculate the position size we can use a simple calculation; divide the capital we will risk per trade of $200 by the share price risk of $0.25.
Position Size: $200/$0.25
= 800 XYZ CFDs
If the share price where to fall to $4.75 and we were stopped out we would loose $200 or 2% of our available capital.
Lets now take another look at the key aspects of this trade after incorporating the “‘fixed percentage risk method’
|Percent at Risk||2%|
| Capital at Risk ||$200|
|Share Price Risk||$0.25|
|Position Size||800 CFDs|
For many traders it would be reasonable to suggest that 2% should be the maximum amount of your capital that is risked on any trade. This percentage can be varied depending on a traders risk tolerance or the size of their capital base. It is important to note that the larger the percentage at risk, the greater the drawdown of capital that may be experienced on each losing trade.
As a rule of thumb; the larger the percentage at risk per trade, the fewer the number of losing trades that can be sustained before it becomes difficult to continue trading.
With a reduced capital base it becomes difficult to trade as it is an uphill battle to return to breakeven.
Using the above example of $10,000, if we were to set a “20% of our capital at risk on each trade we may experience a loss of $2000 on our first trade. In order to recover from this point we need to make a profit of 25% from our remaining $8,000 capital base to break-even.
Many Professional traders protect their capital by risking a smaller percentage on each trade. By applying a “1-2 percentage at risk” rule a trader has much greater capacity to tolerate inevitable losing trades.
A variation of the “percentage” approach is the ‘fixed dollar risk method’. In this model the amount that a trader is willing to risk on each position is fixed and the amount of capital available is irrelevant.
Let’s assume that your capital base has doubled, however the amount that you wish to risk has remained constant at $200.
Position size is calculated in the same format; Capital at risk divided by Market risk
Position Size: $200/$0.25 = 800 CFDs
Using the same trade in XYZ as the previous example;
|Capital @ Stake||$200|
|Share Price Risk||$0.25|
|Position Size||800 CFDs|
Regardless of the size of the capital base, should we be stopped out, the loss will be the nominated amount of $200.
Risk management plays a crucial role in trading success. In order to protect your capital it’s essential that the amount you are prepared to lose is determined before entering a trade. Once this amount is set; it is then possible to establish your position size.
Using a structured approach such as the methods we have discussed today will reduce inconsistency and the influence of your emotions in decision making. Discipline and setting predetermined exit levels are a more professional and hopefully less stressful approach to trading.
Matthew Press, Head of Sales, FP Markets
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