Position sizing is an important concept for both day traders and long-term investors. As the name suggests, it refers to the size of the trades that you initiate and is a vital concept because it can determine your profits and losses and how long you will last as a trader.
In this article, we will look at what position sizing is and how you can use it well in the financial market.
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What is position sizing?
As mentioned above, position sizing refers to the method or technique of determing the size of the asset that you will buy or short in the market. It is important because it will determine the amount of money that your trades will make.
For example, if you buy 1,000 shares of a company, you will definitely make more money than someone who buys 500 shares. On the other hand, if the trade loses money, you will lose more than the person who bought 500 shares.
The same is true across all asset classes like stocks, exchange-traded funds, and commodities.
Position sizing in stocks trading
Position sizing plays an essential role in determining the success of trades in the financial market. There are two main ways of approaching this in stocks. For one, there are stocks that trade for less than $1 and there are others that go for more than $220,000.
Small Trades
Most traders can easily afford to buy a stock that goes for less than $5 but few of them can afford a stock going for more than $200,000. Therefore, most small traders focus on trading the stocks going for less amount of money. Furthermore, with a $1,000 account, you can buy more shares and benefit if it rises.
Fractional Shares
Recently though, many online brokers have started offering fractional shares to their customers. This is a situation where the company allows you to buy a portion of a stock. In the example above, if you have $1,000, you can comfortably buy 0.0045 shares of a company.
Position size in forex trading
As mentioned, position sizing is an equally important concept in the forex market because it can make or break a day trader’s career. Unlike in stocks, forex position sizing is a bit complicated because of how it works. Forex brokers accept volume in form of lot sizes. Typically, lot sizes start at 0.01 and moves upwards.
For example, if you have a $5,000 account, you should first look at the percentage you want to risk. If you are risking 1%, it means that the maximum loss you want to risk is $50. You should then divide this amount by the stop in order to find the value per pip.
»Stop Order VS Stop Limit Order«
In this case, divide $50 and 200 pips and receive $0.25 per pip. In the final stage, you should multiply the value per pip a known unit/pip value ratio. If we use 10k unit for a mini lot, the value will be 2,500 units of the currency.
Since this is a relatively long process, many traders use a free pip calculator that is provided by several platforms like Investing and MyFxBook, as shown below.
How to determine position sizing
Obviously, this cannot be left to chance or done without first making some considerations. Good feelings are important for every trader, but as always this should not put your trading account at risk.
There are several methods and techniques to calculate your position sizing. This is because there are several factors you need to consider when sizing your trades.
Level of Experience
First, you need to consider your level of experience. Many new traders should start by pricing their trades modestly early in their careers. This will help ensure that they are able to test their strategies while risking the least amount of their money.
The size of the account
Second, the size of the account. If you have a $10,000 account, you should open smaller trades than a person with a $1,000,000 account. The logic behind this is relatively simple. For one, if your trade makes a big loss, it will be easier to pare back the losses when you have a big account than a smaller account.
Trading confidence
Third, the confidence of the trade should also play a role. At times, you are almost sure how a stock will trade. For example, if a company releases strong earnings and boosts its guidance, you are almost certain that the stock will jump. In such a case, you can open a relatively big trade. However, such big trades should have a modest tight stop loss to ensure that you can capture the profit easily.
The market volatility should help you in position sizing. In periods of high volatility, you should open modestly small trades to take advantage of the period without risking a lot of money.
Risk-reward ratio
Most importantly, you should always consider your risk-reward ratio when setting your position size. For example, if your goal is to risk a maximum of 5% per trade and you have a $20,000 account, you should ensure that your stop loss is at $1,000 for every trade you initiate.
The risk of aggressive position sizes
Many new day traders lose a lot of money because of two main reasons. They start their accounts with a big leverage and then use large position sizes. Their goal is to make a lot of money within a short period.
For sure, if trades go their way, they will make more money than people who have a small leverage and small trade sizes.
However, in the financial market, things don’t always go right. Even the most perfect traders lose money every week. As such, when that happens, there is usually a possibility that the losing trades will be substantial.
Therefore, we recommend that you use a small amount of leverage, especially when you are starting your career journey.
Summary
Position sizing is an important concept in the financial market. While larger trades can help you make more money, smaller trades are usually safer. As a trader, you should always calculate the sizes of your trades well before you open a trade.
External Useful Resources
- Position Sizing Strategy for Long-Term Success – Old School Value