Learn to Manage Risk with Position Sizing

Risk is a natural part of life.  It accompanies us wherever we go or activity we set out to do.  When we engage in an activity of our choosing, the risk has a balance point.  That balance point is key to allow us to continue the activity many times over.  The risk in trading is no different then other types of risk.  If we take on too little risk, generally we won't achieve our desired return, and if we take on too much, we go broke.   This is where part of risk management through position sizing comes into play as a trader.

Proper position sizing helps protect our capital when we are wrong, but it also allows us to play game over and over again.  By remaining in the game, we will be able to discover trading opportunities that allow us to compound our account year after year.  Trading is not a lotto ticket, but concerted effort to work inside a controlled environment for capital appreciation.  To help control our environment we enact good risk management practices through position sizing.  

Over the course of 15+ years of trading, I've seen many traders lose their principle before they even find a profitable trading method to master.  The reason being that they simply had no concept of managing their position sizing.   It can't be stressed enough that one of the first principles that must be learned in trading is risk management.  Without it, you will soon be parted from your money and likely never come back.  Don't be like most new traders and be blinded by how much money you can make, but instead be fearful of how much money you could lose by not understanding the dynamics of proper position sizing.

To determine the correct position size, I use a % risk model.  Typically I'll risk between .25 to 1% of my account value on one trade.  My one caveat is that I don't exceed 15% of my total account value in any one trade.

What does 1% risk mean? It means the percentage of my total account value that I'm willing to lose on that particular trade.  For a simplistic example, let's assume the total account value is 100K.  A 1% risk models means that I will lose 1,000 dollars if my stop loss is hit. 


Lets make a few quick assumptions:

Account Value:  $100,000

% Risk: 1%

Entry Price: 50

Initial Stop: 45

The first step that I do is to determine the dollar amount that I could lose.  In this case we take $100,000 x 1% which equates to $1,000 on this particular trade.  Next we need to determine the point risk which is 50-45=5.  With these two numbers now determined, we can now calculate the number of shares to purchase by dividing $1,000 by 5, which equals 200 shares.  I then cross check the amount I'm investing to make sure that I'm under 15% of my total account value.  On this trade 200x50 =10,000 which will be the amount invested.  10000/100000 is only 10% of my total account value.  Since this falls under 15% of my total account value,  the entire 200 share trade will be executed.

 This approach as outlined will typically see us have 6-12 total positions when we are fully invested.  I've found that this allows me to take enough risk to achieve solid returns but not so much risk that I can be left out in the cold.  The 15% limit works as a fail save in the event that a stock gaps down significantly below your initial stop loss.

This position sizing approach is just one tool in your set to help you take control of your trading. Other key factors such as situational awareness, stock selection, and your return objectives combined with other risk management tools will help you master trading.   Proper position sizing will help control risk and also help you find the right balance point in your trading.  You will be able to keep playing the game and possibly make millions.

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