How to Calculate Position Size in Trading

How to Calculate Position Size in Trading

Introduction

No matter how big your portfolio is, youll need to exercise proper risk management. Otherwise, you may quickly blow up your account and suffer considerable losses. Weeks or even months of progress can be wiped out by a single poorly managed trade.

A fundamental goal when it comes to trading or investing is to avoid making emotional decisions. As financial risk is involved, emotions will play a huge part. Youll need to be able to keep them in check so that they dont affect your trading and investment decisions. This is why its useful to come up with sets of rules that you can follow during your investment and trading activities.

Lets call these rules your trading system. The purpose of this system is to manage risk, but equally importantly, to help eliminate unnecessary decisions. This way, when the time comes, your trading system wont allow you to make hasty and impulsive decisions.

When youre establishing these systems, youll need to consider a few things. Whats your investment horizon? Whats your risk tolerance? How much capital can you risk? We could think of many others, but in this article, well focus on one specific aspect how to size your positions for individual trades.

To do that, first, well need to determine how big your trading account is, and how much of it youre willing to risk on a single trade.

How to determine account size

While this may seem like a simple, even redundant step, its a valid consideration. Especially when youre a beginner, it may help to allocate certain parts of your portfolio to different strategies. This way, you can more accurately track the progress youre making with different strategies, and also reduce the chance of risking too much.

For example, lets say you believe in the future of Bitcoin and have a long-term position tucked away on a hardware wallet. Its probably best not to count that as a part of your trading capital.

In this way, determining the account size is simply looking at the available capital that you can allocate to a particular trading strategy.

How to determine account risk

The second step is determining your account risk. This involves deciding what percentage of your available capital youre willing to risk on a single trade.

The 2% rule

In the traditional financial world, theres an investing strategy called the 2% rule. According to this rule, a trader shouldnt risk more than 2% of their account on a single trade. Well go over what that means exactly, but first, lets adjust it to be more suitable for the volatile cryptocurrency markets.

The 2% rule is a strategy suitable for investment styles that typically involve entering only a few, longer-term positions. Also, its typically tailored to less volatile instruments than cryptocurrencies. If youre a more active trader, and especially if youre starting out, it could be lifesaving to be even more conservative than this. In this case, lets modify this to be the 1% rule instead.

This rule dictates that you shouldnt risk more than 1% of your account in a single trade. Does this mean that you only enter trades with 1% of your available capital? Absolutely not! It only means that if your trade idea is wrong, and your stop-loss is hit, youll only lose 1% of your account.

How to determine trade risk

So far, weve determined our account size and account risk. So, how do we determine the position sizing for a single trade?

We look at where our trade idea is invalidated.

This is a crucial consideration and applies to almost any strategy. When it comes to trading and investing, losses will always be a part of the game. As a matter of fact, theyre a certainty. These are a game of probabilities not even the best traders are always right. Actually, some traders might be wrong much more than they are right and still be profitable. How is that possible? It all comes down to proper risk management, having a trading strategy, and sticking to it.

As such, every trade idea must have an invalidation point. This is where we say: our initial idea was wrong, and we should get out of this position to mitigate further losses. On a more practical level, this just means where we place our stop-loss order.

The way to determine this point is entirely based on individual trading strategy and the specific setup. The invalidation point can be based on technical parameters, such as a support or resistance area. It could also be based on indicators, a break in market structure, or something else entirely.

There isnt a one-size-fits-all approach to determining your stop-loss. Youll have to decide for yourself what strategy suits your style the best and determine the invalidation point based on that.

How to calculate position size

So, now, we have all the ingredients we need to calculate position size. Lets say we have a $5000 account. Weve established that were not risking more than 1% on a single trade. This means that we cant lose more than $50 on a single trade.

Lets say weve done our analysis of the market and have determined that our trade idea is invalidated 5% from our initial entry. In effect, when the market goes against us by 5%, we exit the trade and take the $50 loss. In other words, 5% of our position should be 1% of our account.

  • Account size $5000
  • Account risk 1%
  • Invalidation point (distance to stop-loss) 5%

The formula to calculate position size is as follows:

position size = account size x account risk / invalidation point
position size = $5000 x 0.01 / 0.05
$1000 = $5000 x 0.01 / 0.05

The position size for this trade will be $1000. By following this strategy and exiting at the invalidation point, you may mitigate a much larger potential loss. To properly exercise this model, youll also need to take into account the fees youre going to pay. Also, you should think about potential slippage, especially if youre trading a lower liquidity instrument.

To illustrate how this works, lets increase our invalidation point to 10%, with everything else being the same.

position size = $5000 x 0.01 / 0.1
$500 = $5000 x 0.01 / 0.1

Our stop-loss is now twice the distance from our initial entry. So, if we want to risk the same $ amount of our account, the position size we can take is cut in half.

Closing thoughts

Calculating position sizing isnt based on some arbitrary strategy. It involves determining account risk and looking at where the trade idea is invalidated before entering a trade.

An equally important aspect of this strategy is execution. Once youve determined the position size and the invalidation point, you shouldnt overwrite them once the trade is live.

The best way to learn risk management principles like this is through practice. Go to Binance and put your newfound knowledge to the test!

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