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. This may look like them deciding to take a larger position if they feel really confident about a trade, or, alternatively, opting to take a smaller position if they feel a little less confident. However, this may not be the most informed or strategic methodology for determining the size of an investment.
Similarly, a trader should not just elect a pre-determined position size for all trades, regardless of how the trade sets up; this style of trading will likely lead to underperformance in the long run. So, if it's not in the best interest of an investor to select a random position size, and it's not a good idea to set a uniform size for all trades, what is the best way to evaluate the optimal position for a trade? Here are some different methods for traders to determine an optimal position size that may also reduce their risk.
- Traders should develop an informed, strategic methodology for determining the size of a trade, rather than randomly selecting a position or electing a pre-determined position size for all trades.
- Before determining a position size, a trader must first understand the appropriate stop level for a specific trade.
- For a trader, the stop level can help them determine the risk; depending on the size of the account, you should risk a maximum of 1% to 3% of your account on a trade.
- For larger accounts, there are some alternative methods that can be used to determine position size, including implementing a fixed-dollar stop.
Identify the Appropriate Stop Level
Before determining a position size, a trader must first understand the appropriate stop level for a specific trade. Stops should also not be set at random levels. A stop should be placed at a level that will provide the appropriate information for the trader, specifically that they were wrong about the direction of the trade. If a stop is placed at an inappropriate level, it may easily be triggered by normal movements in the market.
For a trader, the stop level can help them determine the risk. For example, if the stop is 50 pips from a trader's entry price for a forex trade–or assume 50 cents in a stock or commodity trade–the trader can then start to determine their position size.
The first consideration should be the size of your account. If you have a small account, you should risk a maximum of 1% to 3% of your account on a trade.
For example, if a trader has a $5,000 trading account, and the trader risks 1% of that account on a trade, this means they can lose $50 on a trade. So, this trader can take one mini-lot. 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 they can lose $150 (which is 3% of the account). So, with a 50-pip stop level, they can take three mini-lots. If the trader is stopped out, they will have lost 50 pips on three mini lots, or $150.
In the stock market, risking 1% of your account on the trade would mean that 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. In this case, the risk for the trade has been contained to a small percentage of the account, and the position size has been optimized for that risk.
Alternative Position-Sizing Techniques
For larger accounts, there are some alternative methods that can be used to determine position size. A person with a $500,000 account may not always wish to risk $5,000 or more (which is 1% of $500,000) on every single trade. They might have many positions in the market, they may not actually employ all of their capital, or there may have liquidity concerns with large positions. In this case, a fixed-dollar stop can also be used.
Let's assume a trader with an account of this size wants to risk only $1,000 on a trade. They can still use the method mentioned above. If the distance to the stop from the entry price is 50 pips, the trader can take 20 mini-lots, or 2 standard lots.
In the stock market, the trader could take 2,000 shares with the stop being 50 cents away from the entry price. If the stop is hit, the trader will have lost only the $1,000 that they were willing to risk before placing 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 and require flexibility in their position-sizing decisions. A daily stop means the trader sets a maximum amount of money they can lose in a day, week, or month. If traders 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 a day, then they should set a daily stop-loss that 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 history of profitable trading–or who are extremely active in trading throughout the day–the daily stop level allows them the freedom to make decisions about position size on the fly throughout the day and yet still 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.
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.
The Bottom Line
To achieve the correct position size, traders need to first determine their stop level and the percentage or dollar amount of their account that they're willing to risk on each trade. Once we have determined these, they can calculate their ideal position size.