Optimal Position Size Reduces Risk

Determining how much of a currency, stock or commodity to accumulate on a trade is an often-overlooked aspect of trading. Traders frequently take a random position size. They may take more if they feel "really sure" about a trade, or they may take less if they feel a little leery. These are not valid ways to determine position size. A trader should also not take a set position size for all circumstances, regardless of how the trade sets up, and this style of trading will likely lead to underperformance over the long run. Let's look at how position size should actually be determined.

The first thing we need to know before we can actually determine our position size is the stop level for the trade. Stops should not be set at random levels. A stop needs to be placed at a logical level, where it will tell the trader they were wrong about the direction of the trade. We do not want to place a stop where it could easily be triggered by normal movements in the market.

Once we have a stop level, we now know the risk. For example, if we know our stop is 50 pips from our entry price for a forex trade (or assume 50 cents in a stock or commodity trade), we can now start to determine our position size. The next thing we need to look at is the size of our account. If you have a small account, you should risk a maximum of 1% to 3% of your account on a trade.

Assume a trader has a $5,000 trading account. If the trader risks 1% of that account on a trade, this means he or she can lose $50 on a trade, which means the trader can take one mini-lot. If the trader's stop level is hit, then the trader will have lost 50 pips on one mini lot, or $50. If the trader uses a 3% risk level, then he or she can lose $150 (which is 3% of the account). This means that, with a 50-pip stop level, he or she can take three mini-lots. If the trader is stopped out, he or she will have lost 50 pips on three mini lots, or $150. (Learn more about implementing appropriate stops in: A Logical Method of Stop Placement.)

In the stock market, risking 1% of your account on the trade would mean that a trader could take 100 shares with a stop level of 50 cents. If the stop is hit, this would mean $50, or 1% of the total account, was lost on the trade. In this case, the risk for the trade has been contained to a small percentage of the account, and the position size has been optimized for that risk.

For larger accounts, there are some alternative methods that can be used to determine position size. A person trading a $500,000 or $1 million account may not always wish to risk $5,000 or more (1% of $500,000) on each and every trade. They may have many positions in the market, they may not actually employ all of their capital, or there may be liquidity concerns with large positions. In this case, a fixed-dollar stop can also be used.

Let's assume a trader with an account of this size wants to risk only $1,000 on a trade. He or she can still use the method mentioned above. If the distance to the stop from the entry price is 50 pips, the trader can take 20 mini-lots, or 2 standard lots.

In the stock market, the trader could take 2,000 shares with the stop being 50 cents away from the entry price. If the stop is hit, the trader will have lost only the $1,000 that he or she was willing to risk before placing the trade. (For more, see: Calculating Risk and Reward.)

Another option for active or full-time day traders is to use a daily stop level. A daily stop allows traders who need to make split-second judgments and require flexibility in their position-sizing decisions. A daily stop means the trader sets a maximum amount of money he or she can lose in a day, week or month. If traders lose this predetermined amount of capital, or more, they will immediately exit all positions and cease trading for the rest of the day, week or month. A trader using this method must have a track record of positive performance.

For experienced traders, a daily stop loss can be roughly equal to their average daily profitability. For instance, if, on average, a trader makes $1,000 a day, then he or she should set a daily stop loss that is close to this number. This means that a losing day will not wipe out profits from more than one average trading day. This method can also be adapted to reflect several days, a week or a month of trading results.

For traders who have a have a history of profitable trading, or who are extremely active in trading throughout the day, the daily stop level allows them freedom to make decisions about position size on the fly throughout the day and yet still control their overall risk. Most traders using a daily stop will still limit risk to a very small percentage of their account on each trade by monitoring positions sizes and the exposure to risk a position is creating. (For more info, read: Would You Profit as a Day Trader?)

A novice trader with little trading history may also adapt a method of the daily stop loss in conjunction with using proper position sizing – determined by the risk of the trade and his or her overall account balance.

In order to achieve the correct position size, we must first know our stop level and the percentage or dollar amount of our account we are willing to risk on the trade. Once we have determined these, we can calculate our ideal position size. (For additional reading, check out: Risk Management Techniques for Active Traders.)