How To Calculate Position Size in Trading
When trading, your trade, as well as position size, is more vital than your entry and exit points. As a trader, you could have the best trading strategy in the world, but if your trade size is too small or too big, then most likely, either taken too little or too much risk and risking too much can affect the trading account quickly. It is essential to understand that position size is not chosen randomly, and it is neither based on how sure you are that a particular trade will work out. Position size is determined by a basic mathematical formula that helps to maximize returns on the risk taken as well as help control risk. There are three steps that are used to determine the proper position size, and they are also applicable for any market, but before examining those three steps, it is necessary to know the appropriate definition of position size.
What is Position Size?
Position size or sizing revolves around the number of units which is invested in a particular security by a trader or investor. When attempting to determine the appropriate position size, it is necessary to take into account an investor's risk tolerance and account size. Position size also refers to the dollar amount an investor will trade or the size of the position within a particular portfolio. Investors make use of position size to determine how many units of security they can purchase, which will, in turn, help them to maximize returns and control risk. The term position size, while essential in most investment types, is one concept that is closely associated with currency trading and day trading.
Why is it Important To Calculate Position Size?
Determining your position size is a crucial factor in risk management, and it is no news that the risk management strategy can determine whether you live to trade another day or not. Knowing your position size can keep you from risking more than necessary as well as blowing up your account. Without knowing your position size, it can result in taking trades that are too large. This will make you highly vulnerable when the markets move, even if it is just a few pips against you.
Steps Involved in Calculating Your Position Size
Making use of the correct position size as well as getting an accurate position size involves implementing and critically examining three different factors in other to determine the best decision to take or course of action. These three factors are;
Before an investor or trader can make use of an accurate or proper position sizing for a particular trade, such an individual must, first of all, determine his/her account risk. This is usually expressed as a percentage of the trader's capital. One major guiding rule for traders or investors entails not risking more than 1% of their capital on any single trade. In other words, even if your account is small or large, a single trade should out more than 1% of your trading capital at risk, which means on a 1000 dollars account, it is advisable not to risk more than 10 dollars on a single trade.
Some traders choose to risk up to 2% of their account per trade, which is not recommended. Practically on a 25,000 dollar account, you can risk 500 dollars per trade, and on a 50,000 dollars account, you can risk 1000 dollars. You might be wondering why only risk 1%? Some might find this hard to believe, but even the best traders are capable of experiencing a string of losses. However, if the risk is kept below 1% per trade, even if in a row you lose ten trades, which is rare of course, you will still have almost all your capital, but if you risked 10% of your account on each trade and in a row lost 10, it would be a major loss. You can also still make great returns by risking just 1% or less on each trade.
Determine Trade Risk
in other to determine your position size, it is necessary to set a stop-loss order. What is a stop-loss order? It is an order that closes out the trade if the price moves against the trader and reaches a certain price. This order is usually put in place at a logical spot, which is out of the range of regular market movements. In a situation where it hit, it lets traders become aware that they are wrong about the market direction, at least for that moment. Trade risk is essential for traders in other to move to the next step in determining an accurate and proper position size. In forex trading, trade risk is usually measured in "pips," while in the stock markets, trade risk is measured in dollars or cents, and for the future market, it is measured in points or ticks.
Calculate Proper Position Size
At this point, you are equipped with all the necessary information which you will need in other to calculate the proper position size for any trade. You are not only aware of your account risk, but you also know your trade risk. with each trade, trade risk tends to fluctuate, and your account risk overtime will also fluctuate as there are changes to your balance; hence your position sizes will vary from one trade to the next
Different formulas are used to calculate position size for respective markets like the forex market, stock market, and future market. For example, to calculate position size for the stock market, make use of this formula; Account Risk divided by Trade Risk is equal to position size in shares. Let's say you have a 100,000-dollar account; this means on each trade, you can risk 1000 dollars, which is equivalent to 1% on each trade. If you buy 100 dollars worth of stock and place a stop loss at 98 dollars, your trade risk will be two dollars. You divide your account risk, which is 1000 dollars, by your trade risk, which is 2 dollars, and your answer, which is 500 shares, is the ideal position size for this trade because, based on your stop-loss s well as entry, you are risking only 1% of your account. The trade costs you 500 shares multiplied by 100 dollars, which is 50,000 dollars, meaning leverage is not required as you have enough capital in your account in other to make this trade.
It is no doubt that calculating position size in trade is not just essential but also beneficial. It serves as a crucial factor towards risk management in other to efficiently maximize profit as well as avoid loss.
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