Position Sizing Is Critical In Trading

Follow These Rules And Watch Your Profit Grow

Position sizing is basically a process to calculate the amount of money that you will invest into a trade based on all of the rules from previous trading articles. Position sizing isn’t about guess work – it is an exact science. The example below will show the process in more detail.

Example

Your trading rules are as follows:

· You will not place more than 25% of your account in any one trade
· You will not risk more than 2% of your account in any one trade
· Your stop loss is based on a 10 day average of the Average True Range (ATR) and is placed at 2 times the value from the low of the day

Your current account is worth $20,000

The brokerage fees are $40 (to buy and sell the stock)

You are currently looking at stock XYZ with a current value of $10 per share

The ATR of the stock is currently $0.10

The Process

The following process will enable you to calculate how much you will place on the trade and whether it will conform to your risk criteria.

Firstly, 25% of your trading float of $20,000 is $5,000. This is the total value of shares that you will buy

The shares are currently at a value of $10. As you are prepared to spend a maximum of $5,000 on the trade (from point 1 above), you will purchase 500 shares of XYZ

Your stop loss is twice the ATR value. As ATR in this instance is $0.10, the stop loss will be set to 10-(2*ATR) = 10-(2*0.1) = $9.80

Now, you will only risk a maximum of 2% of your trading float on any one trade. This is the equivalent of $400 (2% of $20,000).

Your brokerage fees need to be taken into account. As they are $40, this means that you can only risk a maximum of $360 on the price movement of shares (taken from $400 in point 4 minus the brokerage fees)

You will purchase 500 shares at $10 and exit if they reach $9.80. This means that if you are “stopped out” of your trade, the value of the shares would be $4,900.

If you were stopped out of the trade, the amount of money that you would have lost from the trade will be the equivalent of $100 ($5,000 - $4,900). This is less than the original risk set out in point 5 of $360.

The conclusion of this process in this instance is that the trade conforms to all your trading rules and criteria. The trade does not involve excessive risk. In summary, you will enter the trade at $10 and purchase 500 shares. You will exit the position if it reaches $9.80 per share.

A Further Example

If the above had an ATR of $0.40, then the stop loss would be set to:
$10 – (2*0.4) = $9.20.

This would mean that the stock would be exited at a value of:
$9.20 * 500 = $4,600

This would mean that the overall risk involved with the movement of shares is:
$5,000-$4,600 = $400

This would mean that the overall risk is more than the $360 that has been outlined. This suggests that the trade is too risky and should not be entered.

Using the above process will enable you to keep out of risky trades and keep you in trades that offer a better risk profile. Using this strategy will limit your losses during losing streaks and allow your account to grow during winning streaks.

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