Position sizing - How to avoid crippling losses?

Hello everybody, wrote an article about position sizing, and here is its quick summary:

Position sizing is determining the correct size of the position based on the amount of money you risk on the particular trade.

Before you can do that, you need to figure out what is the maximum acceptable risk of the trade.

That risk is usually expressed as a % of your balance, that you are willing to lose.

To make sure you don’t lose more than this amount traders set a Stop Loss order which are the real maximum exposure of your position.

If you don’t use a stop loss, you are exposing your entire portfolio!

Where to put a stop loss?

• That’s where Technical Analysis can be handy. Majority of retail traders would look at the chart to find out – usually behind some support/resistance level or based on some volatility indicator, such as ATR

Rule of thumb:

Risk between 1-3% of your portfolio balance on each position. This way any single individual loss won’t wipe your account and break your spirit. And more importantly, even a string of losses will leave you with enough ammunition to recoup the losses.

Have a clear approach to risk:

1. Set a risk limit for each trade, asset in general, day, week and month (you won’t risk more than X account)
2. Determine the right position size and start small
3. Increase the position size of trades slowly if your account grows
4. Lower size or switch back to paper trading if your account doesn’t

Two types of position sizing methods: Fixed and flexible

Fixed position size

• Using the same position size for every trade
• Good for finding out if your strategy has an edge
• Make sure you come back and reevaluate position size periodically.

Flexible position size

• Using a percentage of current balance
• Cluster of wins makes every following win larger
• Cluster of losses makes every following loss smaller

How to calculate the correct position size:

You need to know

1. Trading account size
2. Acceptable risk (in % per each trade)
3. Invalidation point (in form of a distance from the open price)

The formula:

Position size = Trading account size x Acceptable risk / Invalidation

Example:

1. Trading account size = $10,000
2. Acceptable risk = 1%
3. Invalidation point = 4% drop in market price

Position size = $10,000 * 0,01 / 0,04 = $2,500

This way you will always risk losing $100 no matter where your Stop Loss goes! If Stop Loss must be wider, say 8%, the calculation is:

Position size = $10,000 * 0,01 / 0,08 = $1,250

Doubling the distance to our stop loss has us reducing our position size by half to maintain the same possible loss.

How to set position size in the trading platform

1. Pick a leverage
2. Add a Stop Loss
3. Input the market price or the distance in % of the stop loss - Whichever value you enter first, that becomes the constant – element that won’t change when you edit other variables. You can select different constant by clicking the “target” icon -
4. Input the Position Size or Margin size while watching the PnL of the Stop Loss - Increase or decrease the size of the position, until the PnL of the Stop Loss is at the level you want it to be-

This way you can control exactly what your exposure is, while understanding all the variables involved. You can even add multiple Stop Loss orders, which can help you limit the exposure in lower conviction plays, such as new set-ups. Full article is on blog.cleo.finance

The next article will be about Stop Losses.