Trading Risk Management: An Overview of How We Decide Our Position Sizes
Risk management is an area of trading that is often overlooked by many new traders, this is especially true when it comes to position sizing. We receive many emails from traders complaining about their trading performance, which allows us to find the root cause of many problems. One of the main causes is the lack of risk management.
By finding the right position size for a trade, you can maximise your profit in good situations, while minimising your potential losses in risky situations.
Broadly speaking, there are two main approaches to position sizing that most traders use: static and dynamic position sizing. We don’t encourage the use of static position sizing, as I will explain.
Static Position Sizes
There are a number of different ways that traders use static position sizes and each of them is an inappropriate method.
The first method is when a trader uses a standard position size for every opportunity. This means the size of the trade is only linked to the size of the account, rather than the opportunity itself.
For example, if a trader opens one lot for every $10,000 in their account. This means if they have a $10,000 account they will open one lot and if they have a $30,000 account they will open three lots.
Let’s go through an example:
Imagine you have a trade with a relatively high expected chance of success. The trade requires a 10 pip stop loss and when opening one lot, this works out at 1% of the account at risk. That may sound quite reasonable, right?
However, what if the next trade has a relatively low expected chance of success (lower than the previous trade but high enough to justify entering the trade). This time the trade requires a 30 pip stop loss. That means based on opening the trade with one lot, the amount at risk for this trade is 3%.
Is this reasonable? Is it justified?
In the first trade, you have a greater chance of success (therefore, a lesser chance of losing money) and you are risking 1% of the account. In the second trade, you have a lesser chance of success (therefore, a greater chance of losing money)…