The importance of the correct position size
To find the correct position size is something that traders often forget to use. It is not unusual that many traders are using a random position size for their trades. They decide to use a bigger position if they feel that a trade is more likely to make profit, or they choose to use a smaller position size if the trade feels more likely to be a losing one. Although this may feel safer to do so, this is not the best or most strategic method for determining the size of a position.
Before you enter a trade you have to prepare your position first. These preparations are necessary to protect your portfolio as well as possible. When you have figured out what your entries are, where your take profits are and where your stoploss is placed, the only thing you have to do is calculate how big your position size has to be.
The most important aspect what traders should understand and apply correctly is the stoploss order. These type of orders can not be placed anywhere random. The stoploss order should be placed on a level that gives the trader the needed information in case they are wrong, especially when the market moves in the opposite direction of your setup. If your stoploss order is not placed correct, the order could be activated unintentionally by the market movements. The stoploss order should be placed when the trade is not valid anymore. In that case you want to be out of your position as fast as possible.
How do I calculate my correct position size?
In the example below we will set out stoploss at 5% of our purchase price. We set our target at 10% of our purchase price.
Let’s say we have a portfolio of $10.000 and we would like to risk 1% of that portfolio. In other words, the amount we would like to risk in case we will lose the trade is $100.
The desired position size can be calculated by the following formula:
Trade amount = $ Risk / (SL % /100 )
Trade amount = $100 / (5/100 )
Trade amount = $100/0.05 = $2000