Money management is vital to becoming a successful trader. In fact, I believe it’s the most important thing.
One of the components is sizing your positions properly. You should scale up (or down) the size of your trades depending on how much profit buffer you have.
That’s all about putting your profit and loss (P&L) tally to work and protecting your capital if things don’t go to plan…
That might seem like a simple concept on the surface.
But I’ve found that position sizing is really challenging to get right. There’s no “one size fits all” approach that works.
What’s more, many traders overlook one critical factor…
Choosing a Position Size
The purpose of position sizing is to determine what size a trade should be. The most common place to start is a fixed percentage of your trading funds.
This reflects the maximum size you’re prepared to lose on a trade. So, for example, someone with a $100,000 account who’s prepared to risk 2% would put a maximum of $2,000 into any trade.
To be clear, $2,000 isn’t a fixed number. You’re not required to put that much into a trade. When you’re trading an extremely volatile asset, like a crypto, you might opt for a smaller position than a blue-chip stock.
The idea is to get the right balance between your account size and risk tolerance, so that no individual trade can knock you out of the game. Having set those parameters, the critical thing is to stick with them.
But one of the more difficult decisions is working out what percentage of your account you want to use… especially if you’re new to trading.
Some folks might be totally comfortable with a 5% maximum risk – or even higher. Yet for others, even a 2% max risk might keep them up at night.
So you need to work out what best suits your comfort level.
And beyond this fixed percentage, there’s another side of the equation. Understanding this was pivotal to me successfully trading my own account… and later my hedge fund…
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The Forgotten Factor of Position Sizing
Most position sizing theory focuses on the risk side – determining how much you’re prepared to lose.
But you also need to consider how much you can make in profits. That’s what ultimately determines if, and how long, it takes to get any losses back.
Take, for example, a trader who takes multiple 3% hits over successive months without making much (or any) of that money back. Within three to four months, their account could be down around 25-30%.
The losses become so great that the challenge of getting out of the hole is just too daunting – even for professional traders who’ve made money regularly for years.
You need to be confident in how much money you can consistently generate from trading and adjust your maximum risk percentage accordingly.
Similarly, if you’re going through a rough patch, consider winding down that maximum loss percentage. That will help stop losses from accumulating into something substantial.
So by all means, look at the risk side of the equation when it comes to position sizing. Consider how much you’re prepared to lose given your account size and risk tolerance.
But don’t view that in isolation…
You also need to consider how regularly you can bank profits and their size. Use that to adjust that maximum loss as required.
And that will put you on the right track to position sizing… and money management.
Regards,
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
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