Optimal Position Size Reduces Risk

By Cory Mitchell AAA

Determining how much of a currency, stock or commodity to accumulate on a trade is an often overlooked aspect of trading. Traders frequently take a random position size; they may take more if they feel "really sure" about a trade, or they may take less if they feel leery. These are not valid ways to determine position size. A trader should also not take a set position size for all circumstances. Many traders take the same position size regardless of how the trade sets up, and this style of trading will likely lead to underperformance over the long run.

What Affects Position Size
Let us look at how position size should actually be determined. The first thing we need to know before we can actually determine our position size is the stop level for the trade. Stops should not be set at random levels. A stop needs to be placed at a logical level, where it will tell the trader they were wrong about the direction of the trade. We do not want to place a stop where it could easily be triggered by normal movements in the market. (Learn more in 4 Factors That Shape Market Trends.)

Once we have a stop level, we now know the risk. For example, if we know our stop is 50 pips (or assume 50 cents in stock or commodity) from our entry price, we can now start to determine our position size. The next thing we need to look at is the size of our account. If we have a small account, we should risk a maximum of 1-3% of our account on a trade. The percentage of the account we are willing to risk is often misunderstood, so let's look at a scenario.

Assume a trader has a $5000 trading account. If the trader risks 1% of their account on a trade, that means the trader can lose $50 on a trade, which means they can take one mini lot for the trade described. If the trader's stop level is hit then the trader will have lost 50 pips on one mini lot, or $50. If the trader uses a 3% risk level, then he or she can lose $150 (which is 3% of their account), which means with a 50-pip stop level he or she can take 3 mini lots. If the trader is stopped out, they will have lost 50 pips on 3 mini lots, or $150. (Learn more about implementing appropriate stops in our article, A Logical Method Of Stop Placement.)

In the stock markets, risking 1% of your account on the trade would mean a trader could take 100 shares with a stop level of 50 cents. If the stop is hit, this would mean $50, or 1% of the total account, was lost on the trade. The risk for the trade has been contained to a small percentage of the account and the position size optimized for that risk.

Alternative Position-Sizing Techniques
For larger accounts, there are some alternatives which can also be used to determine position size. A person trading a $500,000 or $1,000,000 account may not always wish to risk $5,000 or more (1% of $500,000) on each and every trade. They have many positions in the market, they may not actually employ all of their capital, or there may be liquidity concerns with large positions. Therefore a fixed-dollar stop can also be used. Let us assume a trader with an account of this size only wants to risk $1,000 on a trade. They can still use the method mentioned above. $1,000 is their chosen maximum stop (this is even less than 1% of the account capital). If the distance to their stop from the entry price is 50 pips, they can take 20 mini lots, or 2 standard lots.

In the stock market they could take 2,000 shares with their stop being 50 cents away from their entry price. If the stop is hit, the trader will only have lost the $1,000 they determined they were willing to risk before they placed the trade.

Daily Stop Levels
Another option for active or full-time day traders is to use a daily stop level. A daily stop allows traders who need to make split-second judgments flexibility in their position sizing decisions. A daily stop means the trader sets a maximum amount of money they can lose in a day (or week, or month). If they lose this predetermined amount of capital, or more, they will immediately exit all positions and cease trading for the rest of the day, week or month). A trader using this method must have a track record of positive performance.

For experienced traders, a daily stop loss can be roughly equal to their average daily profitability. For instance, if on average a trader makes $1,000/day, then they should set a daily stop loss which is close to this number. This means that a losing day will not wipe out profits from more than one average trading day. This method can also be adapted to reflect several days, a week or a month of trading results.

For traders who have a have a history of profitable trading, or who are extremely active in trading throughout the day, the daily stop level allows them freedom to make decisions about position size on the fly throughout the day, and yet control their overall risk. Most traders using a daily stop will still limit risk to a very small percentage of their account on each trade by monitoring positions sizes and the exposure to risk a position is creating. (Read Would You Profit As A Day Trader? for more info.)

A novice trader with little trading history may also adapt a method of the daily stop loss in conjunction with using proper position sizing - determined by the risk of the trade and their overall account balance.

Conclusion
Determining the proper position size before a trade can have a very positive impact on our trading results. Position size is adjusted to reflect the risk involved in the trade. In order to achieve the correct position size, we must first know our stop level and the percentage or dollar amount of our account we are willing to risk on the trade. Once we have determined these, we can calculate our ideal position size. (Ready to quit your day job and become a full-time trader? These tips will help you determine your area of expertise. Read Quit Your Job To Trade Stocks?)

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