Most traders focus on entering and exiting trades. But are you allocating the correct amount of capital to positions? This post will discuss the underappreciated science of trade sizing.
Without proper trade sizing, even though you might have more profitable trades than unprofitable trades, one or two big losses can erase all your gains. The size of any position should be appropriate for the size of your account and reflect a maximum acceptable risk or loss.
Where Traders Get in Trouble
Talking to traders, I am surprised how little thought many give to trade size. It seems like a random number generator determines their trade size. Some risk 1 percent on one trade, 5 percent on another and 20 percent on another. That means your entire account can get wiped out if the larger positions lose money.
Another disadvantage of trading too large a position for your account is that it reduces your flexibility to set a proper stop-loss level. You want to find a balance between account risk and room for normal price action and volatility. Setting your stops too tight because your trade size is too big is obviously the wrong approach.
The Fixed Fractional Approach
One solution is to never risk more than a certain percent of your account on a single trade. This is often called the “fixed-fractional” approach.
For example, say you risk 10 percent of your account on each position. It only takes a series of maximum losses to erase most of your capital. Then you can’t trade at all!
If, on the other hand, you only risk 1 percent of your account per trade, it would take more than 50 net losers to cut your account in half. Done consistently, it’s better than risking 10 percent or using a random number. But there’s an even better approach.
Using the Spreadsheet
Let’s start with this Excel spreadsheet, available for download here.
Enter your own values into the blue cells:
- Account size in dollars.
- Maximum risk as a percentage of the account.
- Distance in points from your entry price to a stop loss you deem correct.
- Point value of the instrument. (This is $1 for stocks but different for futures.)
Let’s apply this to a hypothetical account with $25,000 of capital. Using fixed-fractional sizing and a maximum risk of 1 percent, your maximum risk would be $250 per trade.
Next, calculate the proper value for a stop loss. First, determine a level appropriate for the security in question. Next, calculate its distance in points from your entry price. This goes into the third blue cell on the spreadsheet.
Say you’re swing trading Microsoft (MSFT) with a 5-point stop loss. The spreadsheet says we can hold 50 shares.
If you buy 50 shares at $140 each and MSFT falls to $135, that would be a 5-point loss. Multiply that times 50 and you have a maximum loss of $250, or 1 percent of the account.
Note that it would cost about $7,000 to place this trade without margin, or about 30% of our account, but we are only risking the $250 stop loss. The cost to place a trade is not a factor in the fixed fractional calculation
Even after placing the correct stop-loss order to manage risk, the market can gap against your positions overnight. This can result in losing much more than the stop-loss — a risk of holding positions from one day to the next. However that risk is much less significant than neglecting proper sizing of your trades. Risk management is worth the effort.
Also, just because you can fund your account with a large amount of money doesn’t mean you should start out risking the full 1 percent on each trade. Practice in the simulator, hone your skills and prove you can make money consistently. Then start trading real dollars with small sizes and increase your size slowly over time.