Risk management is one of the most important concepts in day trading. It refers to a situation where you attempt to maximize profits while reducing risks. It is a topic that we have covered before and highlighted some strategies like position sizing, leverage management, and the need to have a stop-loss.
In this article, we will focus on position sizing and identify some of the best strategies to use.
What is position sizing?
Position sizing refers to how big or small your trades are. It is an important concept because the size of your trades will have an impact on how much money you can make when things go right or how much you can lose when things go south.
Ideally, when you open a large trade, it increases the profit potential that you can make (but also the losses). For example, assume that two people have a trading account with $10,000 each. Also, assume that a stock is trading at $10 and trader A buys 100 shares at $1,000. The next trader decides to buy 1,000 shares at $10,000.
In this case, if the stock rises to $11, the first trader’s profit will be just $100. That’s a very small sum considering that the next trader’s profit will be $1,000.
However, if the stock whipsaws and drops to $6, the first trader will lose just $400 while the other trader will lose $4,000. Therefore, the second trader can be described as a high-risk and high-reward trader. While this trader will make more money when his trades go right, he will also expose himself to more risks if the trades don’t work out.
Therefore, traders are always considering measures to find a balance between opening large and small trades. This is what is known as position sizing.
How to position size well
Traders approach position sizing differently. Still, one of the best approaches to position your size well is on considering the risk and reward ratio. In other words, you need to estimate the amount of risk you are prepared to take for a specific return.
Risk reward + stop loss
There are a number of approaches to this. For example, you can simply come up with a rule that states that you will not expose your account to a specific amount of risk. In most cases, many beginner traders use a risk-reward ratio of about 2%.
For istance, if you have a $10,000 account, it means that you will set a stop-loss where the maximum amount of loss that you can make is $200. For starters, a stop-loss is a tool that stops a trade automatically when it reaches a certain loss level.
Therefore, in this case, if you open a trade, you will need to ensure that the maximum loss you can make is about $200.
Still, there is a better way to calculate the risk-reward ratio. Most advanced traders use their trading journals to identify their win and loss ratio in a given period. For example, assume that you open 30 trades in a month. Of these trades, 25 of them are winning trades. This means that you win about 83% of the time.
You can then compile this data for a few months and see whether the answer is the same or nearly the same. Therefore, if the answer is say, 83%, you can easily use it as part of your risk and reward ratio.
Tip for beginners
Many beginners start with a small risk-to-reward ratio and then increase it as they gain more experience in the market.
In other words, any time you open a trade, ask yourself what the maximum loss is that you are comfortable making and then place a stop-loss there.
Other risk management strategies
There are other risk management strategies to consider when trading. First, you should consider your leverage. Leverage refers to a loan that your broker extends to you in order to maximize your profits. In most cases, a high leverage will lead to more profits.
But it will also expose you to more losses if your trade goes south. Therefore, we recommend that you start your trading journey with a small amount of leverage and then increase it as you gain more experience.
Protect your trades, always
Second, as mentioned above, you should always protect your trades using a stop-loss or a take-profit. These two tools will stop your trades automatically when they test key levels. You should always add these tools in all trades that you enter.
Avoid overnight positions
Third, you should always ensure that you exit all your active trades before the end of the day if you are a day trader. This is important because of the risks associated with gapping when the market opens.
In this article, we have looked at the concept of position sizing and why it is important. We have also looked at other strategies to protect your risks in the market. These include having a stop-loss and a take-profit and always closing your trades before you end your day.
External Useful Resources
- Money Management & Position Sizing: The Key to Profitability - Patternswizard