Position sizing is a method used by traders to determine how much of an asset (like stocks, contracts, or currency) they should buy or sell in a trade. The goal is to manage risk by ensuring that potential losses in any trade stay within a safe, manageable amount of their total capital.
Risk Management: It helps prevent big financial losses from a single bad trade.
Capital Protection: Ensures that even if several trades go wrong, there’s enough capital left for future opportunities.
Emotional Control: Reduces the impact of emotional decisions caused by big wins or losses.
Consistent Returns: Helps traders have more stable results over time by controlling the losses.
Trading Capital: The money available to trade.
Risk Per Trade: The percentage of your capital you’re willing to risk on one trade (usually 1% or 2%).
Stop-Loss: A set price where the trade automatically closes to limit your loss if the market moves against you.
Entry Price: The price at which you enter the trade.
Risk Per Share/Unit: The difference between your entry price and your stop-loss price.
To calculate the position size, you can use this formula:
Position Size = (Trading Capital * Risk Per Trade) / (Entry Price - Stop-Loss Price)
Trading Capital: The total amount of money in your trading account.
Risk Per Trade: The percentage of your capital you are willing to lose on one trade (for example, 1% = 0.01).
Entry Price: The price at which you enter the trade.
Stop-Loss Price: The price at which you will exit if the market moves against you.
Let’s say you have the following:
Trading Capital: $10,000
Risk Per Trade: 1% (0.01)
Stock XYZ Entry Price: $50
Stop-Loss Price: $48
Step-by-Step Calculation:
Determine Maximum Dollar Risk:
Maximum Dollar Risk = $10,000 * 0.01 = $100
Calculate Risk Per Share:
Risk Per Share = $50 (entry price) - $48 (stop-loss price) = $2
Calculate Position Size:
Position Size = $100 (risk) / $2 (risk per share) = 50 shares
Result:
With $10,000 capital and 1% risk per trade, you should buy 50 shares of Stock XYZ. If the price drops to $48 (your stop-loss), your loss will be $100, which is 1% of your capital.