Position Size

As I’ve mentioned before in the risk management section, the maximum amount that a trader should risk on a single trade shall not exceed 3% of his or her deposit, although, I seldom risk more than 1%. 

Let us consider an example of a trade with a 1% risk to the trading deposit.  Our goal is to determine how much we can afford to buy or sell in order to remain within the 1% risk boundaries. 

Imagine you have $100000 on deposit with your broker, you are trading gold futures, and your system tells you to enter long at a price of $970/oz, while your stop is at $960.  How many ounces can you buy without exceeding the 1% risk to your capital?

The mathematics is quite simple – your stop is $10 away from your entry point.  The maximum amount you can lose if the trade goes against you is $1000 (1% of $100000 is $1000). This means that you can only afford to buy 100 oz of gold, because if you bought 100 oz at $970 and were stopped out at $960 you would lose $1000. 

The formula for determining the amount of underlying security to trade is as follows:

Total dollars risked        divided by  dollars in stop-loss  equals Position Size.            (1% of $100 000 = $1000)      /              $10                        =         100 oz

It is important to note that in order to calculate the position size you must know where your stop-loss would be before you open a position.  By doing so you can rest assured that that the most you would lose if the trade goes against you is the 1% you initially intended to risk, and not a penny more. This is a very simple rule, and if you apply it on every single trade, it would allow you to make considerably more than you would if you traded a set amount of ounces.  This is all you need to know about position size.  Take the time to understand this concept thoroughly.  If you are trading stocks, oil or whatever else – the principle is the same.