Proper position sizing is something many traders never even think of, let alone learn to master.
To determine our positions size we must first set a stop level. This should be a logical place which will be out of range of normal market movements, and if hit will be at a level where we know we are wrong about the direction of the market. Remember, a trader should not risk more than 1-2% of capital on a trade. Less is better. Larger accounts are likely to risk much less than 1% of capital on many trades. And risking less than 1% is encouraged.
If our account is $30,000, we can have a maximum loss of $300 if we risk 1% of our capital on the trade. Let’s say we choose a stop which is $0.50 below our entry buy price. From this information we can determine our proper position size; we can take a maximum of 600 shares. If our stop is hit, we will lose $0.50 X 600 Shares, or $300 which was our maximum loss.
Taking 600 shares on this trade allows us to have an ideal stop (this will be different for each trade) and keep our risk in check. As our stop (or risk level) increases on the trade, our position size will decrease, and as our risk (on the trade) decreases our position size can increase. As our account grows our position sizes will also generally increase as we are able to risk more capital on each trade.
It should be pointed out though that simply because 1% should be the maximum does not mean we need to risk that much. A person with a larger account, say $500,000 would likely not risk $5000 on each trade. Instead they may choose to only a risk $1000; this is a fixed dollar stop. If there stop is set to $0.20 away from their entry price, they can take 5000 shares.
Whether we risk a percentage of our account on each trade, or choose a fixed dollar amount we are willing to risk on a trade (for larger accounts) the method above should be employed to determine the proper position size based on the stop level which is ideal for the trade. This means each trade may be for different quantities, depending on the dynamics of the trade set up.
Cory Mitchell, CMT
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**This article is not a recommendation. Consult your own financial professional before making investment or trading decisions. Trading involves substantial risk of loss and the author and/or the distributor of this article will not be held liable for any inaccuracies or losses which may occur as a result of this information.