All successful traders of Forex, Index, Share CFD, and other commodity markets swear by the importance of position sizing their trades. It is essential because you could risk a massive chunk of your trading capital if you don’t have proper position sizing strategies. This means the bigger the risk you take in a trade, the bigger the chances of clearing your trading account.
Are you looking to become a consistently successful trader? First, it’s vital to prioritize risk management: consider limiting your position sizing rather than unnecessarily increasing it.
Let’s take a quick yet comprehensive look at what position sizing is, why it’s essential, and the best position sizing techniques you’ll need to become acquainted with to boost your trade.
First, What Is Position Sizing?
Position Sizing refers to determining the size of a trade and its significant effects on the performance of your trading investment and portfolio. It could also be the number of units invested in a particular security, asset, currency pair, coin, etc., by a trader.
It is always vital to consider a trader’s account size and risk tolerance when determining an appropriate position size, as this would help earn maximum returns at maximal risks.
Position Sizing is an essential concept in all investment types, and it generally associates with intra-day trading in the forex market.
Why is Position Sizing Important?
Here are some of the reasons you should prioritize your position sizing in every trade:
- It determines the size of your position by telling you the number of shares, lots, or contracts to buy for each trade.
- Capital protection.
- Profits maximization.
Top 3 Factors to Consider for Position Sizing
Below are the 3 essential factors to consider for correct position sizing.
1. Account Risk
A trader must determine the account risk most appropriate to utilize the position sizing of a particular trade. Account risk expresses a percentage of the trader’s capital. Successful traders risk no more than 2% of their investment capital on any transaction – fund managers often even attempt a lesser amount.
2. Trade Risk
After determining the account risk, a trader must know where to place their stop-loss order for a particular trade. In other words, the trade risk is the difference between the stop-loss and intended entry prices. A suitable example is a trader willing to purchase a share at $180 and likes to place the stop-loss order at $140; the trade risk is $40 per share.
3. Gap Risk
A trader should know that using correct position sizing doesn’t guarantee zero loss. They may lose more than their specified account risk if a trade or stock GAPS below their stop-loss order. Your Gap Risk is the risk that the price of a commodity, stock, currency pair, or coin will fall from one trade to the next. It typically happens when the price changes level without any trading activity but in response to events or news that occurs when the markers are closed.
4 Expert-Proven Position-Sizing Techniques You Must Know
The best position sizing techniques differ for every trader. It varies by trading pattern and personal risk tolerance. However, if there were one rule a trader had to obey, it would risk a maximum of a few percent of the account in every trade.
Some of the best position sizing techniques include:
1. Fixed Dollar Value/Amount
It is the easiest way to implement position sizing into your trading strategy. This works well for newbie traders and those with small capital. However, you must allocate a fixed dollar amount to every trade. For instance, if you have $50,000 in trading capital, you may consider using $5,000 per trade.
This means you can make 10 trades instead of putting the whole amount in a transaction. This is easy and helps to preserve your capital in case the first few trades you take result in losses.
2. Fixed Percentage Rule
This is an anti-martingale technique. If traders use the $50,000 trading example, they should only risk $500 to $700 per trade.
This technique lets you focus more on the percent risk than the dollar value. So, as your capital increases from $50k to $70k, your 2% risk moves from $500 to $700 per trade. Likewise, you still risk 2% if it decreases, which will be a smaller dollar amount.
3. The Volatile-Based Technique
This technique uses measures of volatility to determine the position size. Trade volatility varies with time, and with greater volatility comes higher swings that need to be considered when considering your trades.
4. Kelly Criterion
John L. Kelly developed this formula. It is used mainly by gamblers and traders to determine the position size of their bet and trade. In addition, this technique helps calculate the percentage of your account that should be risked (K%).
The formula equals the historical win percentage of your trade minus the inverse of the strategy win ratio, divided by the profit or loss ratio. So, for example, getting 0.02 means you should risk 2% of your capital per trade.
Instead of abruptly changing or mixing different position sizing strategies, it is always good to have a consistent plan.
Every trader aims to bag a winning trade irrespective of their technique. As a trader, you are open to many options – there are no binding rules, only the ones you set for yourself.
With this article, I hope you’ve learned about position sizing and the right strategies to get the correct position size for all your trades. If yes, you are one step closer to making consistent trade profits.
Should you have other questions, please leave them in the comment section below. I can’t wait to hear from you!