Many seasoned traders know that position sizing or determining the size of each trade is a vital part of any trading money management 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.
It’s not so difficult to set the size of a specific trade. You just need to take your maximum loss preference converted to a dollar figure and divide it by the trading stop size. The result is the number of units that you can safely purchase at a single transaction.
To get your maximum loss figure, choose a percentage value that corresponds to how much you are willing to lose. It is highly recommended that you risk losing no more than 2% of your trading capital. This is large enough to offer you good profits but is small enough to limit your losses.
There may be a need to fine tune this aspect of managing risk levels. You have to carefully consider the level of risk that you can bear. If you can’t bear too much loss, the figure that comes out after you’ve made your computations may still be too big for you. If so, you can add more rules to your risk management plan. A good extra rule would be to set an additional percentage value that is convertible to dollars for your maximum loss. You can say for instance that you are not willing to let go of 10% or more of your trading float.
Position sizing is not rocket science. The fact that it is a basic concept however should not be enough of a reason for you to give it only a passing glance. It is as important as identifying your trading stops so make sure you don’t skip it.
