Investors want to increase their profits and decrease their risk, and one way to do that is by position sizing. You can use a simple calculation formula to determine the correct position. It is based on the size of your account, the risk of your equity per single trade, the size of your stop-loss, and the number of units (contracts, pips, etc.) comprising your position.
What is position sizing?
Measuring your position size helps you trade with discipline and manage your risk. While most traders use massive leverage and experience wild swings in their portfolios, they use position sizing to smooth the swings. The size of your position within a specific portfolio can be expressed in the size of currency or units that you plan to open.
You have to know what your risk tolerance is in order to decide how much you can risk on a single position, how many units (lots, dollars, pips, shares, etc.) it would require for an appropriate position size, where you place your stop, and how you adjust to market gaps.
What are the critical ingredients to position sizing?
Adequate account risk
In order to determine the correct position size for your trades, you need to choose your account risk first. This means you need to decide what size of your equity you are willing to risk on a single trade. A thumb rule would be that professional traders do not risk more than 1% – 2% of their equity on a single position. This could also be a thumb rule of yours. If you are an active trader, 1% would be the best choice, and if you trade swings and long-term trends, you can go with 2%.
If you have an account of $10,000 and decide to limit your account risk to 2%, the amount that you can risk on a single trade should not exceed $200. This predetermined maximum account risk would help you survive when or if you have a losing streak. If you have 10 consecutive trades that end up in a loss, you would still retain 80% of your initial capital.
Adequate trade risk
After having determined the account risk, you can concentrate on a specific trade. Since you know that you do not want to risk more than 2% of your capital on a single transaction, you will have to adjust your stop loss accordingly. That means that if you enter a buy position for BTC/USDT at $37,000, you need to calculate the distance of your stop loss from the entry price, and make sure that it would not exceed the accepted 2% risk.
The stop position will vary whether you take a leveraged trade, or an unleveraged one. You may actually reduce the number of units you want to trade in order to place your stop-loss further away from your entry price, and contain your potential risk under 2%.
Adequate position size
To determine the correct position size after you have figured out your account risk, and trade risk is quite simple. You need to use the easy formula shown below to calculate it. If you know that you can risk $200 per trade, we can apply the formula to see how many units you can take on a single trade.
Here’s the formula:
[(Account size * risk %) / (Entry price – Stop Loss)] * Entry Price
We use the same example of BTC/USD to calculate how many units would be for a correct position size in our case.
($10,000 * 2%) / ($37,000 – $36,000)] * $37,000 = 0.2 units
So, your position size per this trade is 0.2 units of BTC.
Position size and price gap risk
Markets can be erratic, and not all your orders can be filled if the price for specific asset gaps is because of unforeseen circumstances. Those circumstances could be a speech of the FED chairman, earnings announcements, interest rate decisions or simply a vast demand/supply of orders being filled for a specific price. In this situation, if the price gaps through your stop-loss level, you can lose more than you have anticipated.
If you know that the event is at hand and you still want to open a position, you may also want to reduce it in half, and instead of 2%, risk only 1%. Alternatively, you can decide to skip the event and not trade at all.
Final thoughts
You should base your trading decisions on cold logic that would help you remove emotions out of the equation. It would also prevent you from losing more than you have pre-determined. Choosing the correct position size for your trade allows you to achieve just that.
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
