What It Is and What It Shows
Position sizing helps traders in several key ways:
- Manage Risk: By only risking a small percentage of your trading capital, you ensure that no single trade can significantly deplete your account.
- Maintain Emotional Discipline: By knowing and accepting the potential loss before entering a trade, traders can maintain emotional stability, reducing the chance of rash decisions based on fear or greed.
- Achieve Consistency: Using a consistent position sizing method allows traders to achieve more predictable results over time, rather than experiencing wide fluctuations in account equity.
How to Trade It
Several methods and guidelines can help traders determine appropriate position sizes:
Fixed Percentage Method
With this method, traders decide to risk a fixed percentage of their capital on each trade. For instance, if your capital is $10,000 and you decide to risk 2%, you'd risk $200 on any given trade.
- Example: With a $10,000 account, risking 2% means you can have a stop loss that's $200 away from your entry. If you're trading a stock at $50 and place a stop loss at $48, you'd buy 100 shares (because 100 shares * $2 per share = $200).
Dollar Amount Method
Here, a trader decides to risk a fixed dollar amount on each trade, irrespective of the account size. This method can be less adaptive as the account grows or shrinks.
- Example: Regardless of account size, you might decide always to risk $100 per trade.
Volatility-Based Method
This method uses the asset's volatility to determine position size. For instance, one might use the Average True Range (ATR) as a measure of volatility and decide to risk an amount equivalent to 2x ATR.
- Example: If a stock has an ATR of $1 and you wish to risk 2x ATR, then you're risking $2 per share. If you've decided to risk $200 total on this trade, you would purchase 100 shares.
Kelly Criterion
This is a more advanced method that uses the probability of win and the reward-to-risk ratio to determine the optimal position size. However, traders should be cautious and often use a fraction of the Kelly recommendation to avoid overexposure.
Mental Stops vs. Hard Stops
While deciding your position size, determine if you're using a mental stop or a hard, automated stop. Hard stops automatically sell the position at a predetermined price, while mental stops require manual execution and can be prone to emotional decisions.
Conclusion
Proper position sizing is essential to manage risk and trade sustainably. Always predetermine your risk and position size before entering any trade. By doing so, traders can protect their capital, maintain emotional discipline, and achieve consistent results over time.
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