Today I am going to share with you an effective position sizing strategy that many professional traders use to manage the risk of losing money in the markets. As well as this, I am also providing my position size calculator (link below), to assist you with determining the number of shares, units, or contracts that you should be trading at any given time.
As I’m sure you’ve heard, risk management is the single most important aspect of successful trading. Your risk management processes will quite literally determine your level of success as a trader – even more so than the strategy and the market that you are trading. Your number one objective when trading, even above making money, must be to protect your capital at all times, and ensure that you will always be able to trade another day.
Crowds of people are lured into trading by online gurus who falsely preach about how easy it is to make money. Many of these people open brokerage accounts and look to begin placing trades, without even considering the risk that they may lose their hard-earned money. Losses are an inevitable part of trading, even the very best traders take losing trades all the time. Unfortunately, most beginner traders have poor risk management processes in place which in turn, leads to them wiping out their trading accounts by taking either one or more out-sized losing trades.
The most effective way that you can prevent this from happening to your account is to adopt a structured and proven position sizing strategy. Position sizing is at the forefront of risk management. The size of our position, refers to the number of shares, units, or contracts, that we are trading at any given time. It plays a crucial role in determining the amount of money that we are risking on each trade. There are many traders who like to risk a fixed dollar value on each trade, and others who like to trade with a fixed position size, regardless of the specifics of the trade that they are taking. In my experience, neither of these approaches are optimal. Instead, I recommend an approach widely accepted by professional traders worldwide. It is called the 2% rule. The rule states, “you may never risk more than 2% of your account balance on any given trade”.
By only risking 2% of your account balance on each trade, it would require 38 consecutive losing trades to lose 50% of your initial balance. Losing 38 consecutive trades is a very unlikely scenario – even for someone who knows nothing about trading at all. This rule ensures you are able to lose many trades in a row, whilst inflicting only minimal financial damage on your account. Additionally, by always risking a fixed percentage of your account balance on each trade, the dollar value of your risk will increase when you are performing well and will decrease when you are losing money. It is common practice amongst professional traders to increase their risk parameters when they are performing well, and decrease them when they are not. You will automatically implement this added risk control measure as a function of the 2% rule.
It is common human psychology to be tempted to increase our position sizes after a series of losing trades, to attempt to quickly make back the money that has been lost. Unfortunately, this is a dangerous habit and a sure path to wiping out your trading account. It is imperative that you maintain consistent position sizing practices. By always sticking to the 2% rule, you remove your emotions from the equation, and in turn, give yourself far greater chances of success over a sample size of many trades.
To work out how to size your position to only risk 2% of your account, you can use the following formula:
Account size x 0.02 = Risk
Risk / (Entry Price – Stoploss Price) = Max Position Size
For a step-by-step position sizing example, see the YouTube link at the end of this post.
When trading, you may often be required to work out the size of your position very quickly, and whilst under pressure to ensure you do not miss your entry opportunity. Often going through the calculations to determine your position size manually is less than ideal, and may even cause you to miss a trading opportunity. For this reason, I have developed a Position Size Calculator desktop app that I use daily in my own trading. I have made it available for you to download as I believe it will help you remove the emotion from the position sizing process and ensure you follow the 2% rule with consistency. It has been optimized to take up minimal screen space and for ease of use whilst trading. I have also included the option to set a margin multiplier for traders who trade with a margin account. If you would like to download this calculator for yourself, see the link at the end of this post.
If you are a beginner-level trader, or you are experimenting with a new trading strategy, I recommend taking further risk control measures, until you have proven to yourself that you are able to make a profit. These additional precautionary measures may include, either beginning trading with only a fraction of your total capital or alternatively, limiting your risk to 1%, as opposed to 2% until you show that you are able to produce a profit over a series of many trades.
You must understand that the 2% rule does not mean we have to risk the full 2% of our capital on each trade. Instead, 2% is the maximum risk that you should accept at any given time. There is nothing wrong with risking less than 2%, as long as you are following a structured position sizing approach. Furthermore, you may wish to include any relevant broker commission charges or fees as part of your 2% allowance.
Although there is no way to totally eliminate the risks from trading, it is important that we always do what we can to mitigate and plan for them to the best of our ability. Having detailed risk control measures will ensure that you have the best chances of succeeding as a trader over any significant period of time.
For more information on this topic as well as step-by-step examples on how to calculate your position size both with and without the use of my calculator, check out my extensive YouTube video on this topic.