Many seasoned traders know that position sizing or determining the size of each trade is a vital part of any trading plan. Many beginner traders however make the mistake of not paying adequate attention to this step. They believe that it is enough to simply define the initial stops. This however is a very incomplete way of trying to manage your risks.
Determining the size of every trade is crucial for the protection of your trading float. When you are certain about the number of units that is ideal for you to deal with, you are protecting your capital from getting eroded. Moreover, when you fully delve into proper position sizing, you are also able to identify your win and loss potentials.
What many investors don’t realize is that size matters. The amount that you put in is the indicator of how much you might earn or lose. The more units you purchase, the higher your chances of winning. This is why some immediately invest a lot, thinking that the more risks they take, the more rewards they get. Deciding on this factor however based only on the opportunity to profit well is not advisable. Remember that a big investment also magnifies your chances of losing. To arrive at the best option for you, your risk management system should incorporate a scientific way of defining the extent of an investment.
Getting the right guiding figure to enter a trade isn’t as complicated as you would imagine. You simply have to divide your already predefined maximum loss in dollars by your stop size. The result is the maximum number of units you should purchase on a single trade.
To settle on your maximum loss, identify the percentage of your float that you can bear losing. It is perhaps most sensible to settle for a loss of about 2% because this is neither too small nor too big. To identify your stop size, get the difference between the entry price and initial stop.
In some cases, you may need to further refine this part of your risk management strategy. Depending on your tolerance for risks, you may still view the resulting size as too huge for you. In this case, it would be wise to add another rule to keep your investment money safe. You can set a maximum percentage figure that corresponds to a specific dollar value over which you are not willing to lose. You can say for instance that you are not willing to lose more than 20% of your total float. Hence, if the result of your initial size calculations goes over this, you can follow your extra rule to further scale down your purchase of units.
Position sizing may seem like a technical trading step. In reality though, it is just a sensible way of making sure you don’t drown with the weight of your losses. Do not consider trading without paying due attention to this step. Put as much importance on it as you would on identifying your stops and the size of your float.