There are only three directions for market prices to move; up, down or sideways. And because of this, any layperson can from time to time make a correct market call.
But to make money consistently you need skills in market timing, handling emotions and money management.
Knowing how to position size correctly falls under money management and is the topic covered in this article.
If you aren't a maths whiz, fear not, there is no complex algebra. Just good old fashioned common sense and basic grasp of probability.
What is position sizing?
It's real basic terms it's the art of not betting all your money on one outcome (trade).
Trading is primarily a numbers game.
Probability law tells us that with a positive expectancy system we will, in time come out ahead in any game of chance.
Note those words, in time.
Because despite our best efforts no trading result is ever guaranteed.
To prepare for potential losers, skilled traders divide their capital into small portions.
If you bet the ranch on one trade and it loses; then no positive expectancy trading system is going to help if your funds are gone.
Knowing how to position size correctly is the ability to stay trading long enough for your positive expectance system to start working for you.
How much should you risk on a trade?
Imagine your total stake as a pie, how many times are you going to slice it?
The standard slice in FX and CFD trading, as an end of day trader, is 2%.
For a day trader, usually 1% and a scalper 0.5%.
As an EoD trader, by only risking 2% per trade, even if you lost that amount each time, you could lose many times in a row before your capital dries up.
And even the most appalling system in the world isn't going to produce such poor results.
If you can develop a trading system that wins only 6.5 times out of 10, then you have the makings of a profitable trading career.
Risk allocation during good and bad periods
There is nothing wrong with the 2% rule (or intraday alternatives). These are tried and tested amounts suitable for most beginners.
But they aren't hard and fast rules either.
Other factors can come into consideration. For example:
- how often does the system win?
- how big are those wins?
- how big are the losses?
- how frequent are trades?
- how confident you are?
More experienced traders vary their risk per trade, depending on circumstances.
Reading interviews with some of the world's best traders, in books like Market Wizards, many advocate, when on a winning streak to increase risk.
And when on losing streak to reduce it - often dramatically.
2%, 1%, 0.5% are therefore generic risk parameters. A decent rule, but not one that should be set in stone.
Value per pip/point move
Your trading account will be denominated in a specific currency, depending on where it's located. My own is GBP - yours could be US dollars, Euros, etc
The value per point (or pip) is the amount (in money terms) for every one point (pip) move up or down.
Knowing this value is an important element when it comes to position sizing.
You buy one contract of the UK100 index at 7010.
The value per point is £1.
You sell the position at 7020 - that's a profit of £10 profit
The actual calculation for value per point/pip can be difficult. The formula involves knowing the notional values of contract/lots, and the currency used when trading it.
It can become particularly messy when trading in currency pairs that are not your own currency.
If you want to know more about the formula, Babypips have done a much better job than I could do here.
Fortunately, all broker platforms show value per point/pip per contract if you open an order ticket. If you toggle the number of contracts or lots up or down, the value per point/pip will also change accordingly.
Whenever you enter a trade, you always have an entry point and a pre-determined protective stop loss.
When going long:
Points/pips at risk = entry price - protective stop loss
When going short:
Points/pips at risk = protective stop-loss - entry price
£ risk per one contract traded
Here we multiply the value per point per contract by the total points we are risking.
£ risk for 1 contract = points/pips at risk * value per point/pip
This gives us the £ risk per contract traded.
Of course, the more contracts traded, the larger the £ risk is going to be.
£ total trade risk
This is where we take our total trading capital and divide it up into small portions.
Let's say you're using 2% risk per trade.
You first need to know your total trading stake, we'll make it £3000.
What is 2% of £3000
2/100 * £3000 =£60
Therefore £60 is the £ total trade risk allocated to the next trade.
Remember £60 is not the total stake every time; this calculation needs to be made each time your account goes up or down in value.
If the account is growing £ total trade risk increases, if the account is decreasing so is £ total trade risk.
Determine how many contracts can be traded for the £ total trade risk
This is the final part of the positing sizing process. We now know how much in £s we're risking for one contract traded.
But now we need to know how many contracts can we trade, and still be within our 2% risk model.
The formula is simple enough.
Total allowed contracts to be traded = £ total trade risk/£ risk per trade for one contract
You are not always going to get a number that fits snugly into your £ total trade risk. More often than not you'll have to round up or down the number of contracts.
Usually, this isn't such a big deal, but maybe being slightly risk-averse by rounding down is the better option
Know how to position size
The whole subject of how to position size is a pretty bland subject, certainly not as exciting talking trading strategies.
But, it's a vital topic that needs to be understood.
Many newcomers go wrong because they place too larger a trade size relative to their account equity. This is done as they view their trading account as a way to get rich quick.
You can get rich in trading, but not by betting your entire capital on one quick roll of the dice.
It's consistency and compounding that ultimately brings you wealth in trading, not a gambler's mindset.
Learning how to position size is an essential element for trading success and one worth the time developing.