When you have a defined position sizing, you ensure that your capital remains sustainable under various market conditions. This goes beyond locking potential profits; it mostly lies in the concept of risk management in trading.
Position sizing is an essential risk management technique because it frees you from making irrational trading decisions.
By religiously allocating a predefined capital percentage to each trade, you ensure your account stays healthy and ready for the next trade.
Read on this lesson to explore the risk management benefits of position sizing.
If you’ve gone through TradeGeek from the start to here, you must’ve realized that you’re a risk manager as much as a trader.
Because any financial market is a high-risk environment, participants should be equipped with the knowledge and skills to mitigate risks and profit from them.
One effective way to keep your risk exposure at the lowest level is through position sizing, which involves controlling the size of your trades through positions.
By incorporating position sizing techniques into your trading system, you follow a predetermined capital portion to risk on each of your trades. This keeps you away from the feeling of greed and fear that could cloud your judgment.
Say you follow a portfolio percentage strategy. With this, you only risk 1% of your portfolio/capital to each trade.
Thus, you can only risk USD 500 with a USD 50,000 trading account.
Position sizing can significantly contribute to the profitability of your overall trading system.
Learn more: TradersUnited - All About Position Sizing
Taking calculated actions on each step of trading sets you apart from pseudo-investor gamblers.
Here are five common and beginner-friendly strategies to ensure your position sizing is done correctly.
If you’ve been reading How-to guides on trading, the phrase “Never risk more than 2% of your account on a single trade” probably sounds familiar now.
That notion came from the risk management concept of portfolio percentage.
Portfolio percentage suggests that in every trade you execute, your position sizing should follow the predefined percentage. This ensures sustainable investment every trade needs.
The ideal risk percentage when opening a position is around 1% to 2%. Risking capital more than that could be detrimental when the market moves against your position.
The fixed monetary amount strategy works similarly to the portfolio percentage. But in the fixed monetary amount strategy, a trader risks a predetermined fixed amount – not a percentage.
Picking an amount to risk to all trades should never be based on guts. The predetermined amount of risk must align with your risk appetite and overall financial goal.
Kelly’s formula is more dynamic than the two mentioned above. The amount at risk on each trade varies depending on the profitability of the position.
The higher the probability of winning, the bigger the allocation for the trade should be.
Given the uncertainty of the forex market, Kelly’s formula carries significant risk. Approaching position sizing with this method should be done deliberately, with the market analyzed perfectly.
Note: Kelly’s formula is considered controversial as it blurs the line between strategic investment and gutful gambling.
Formulated by a renowned trader, Larry Williams’ Formula was an improved version of Kelly’s formula. Larry Williams approached this method as more fitting for systematic online trading.
Specifically, this method considers two critical trading variables – the trader’s risk appetite and the maximum drawdown they’ve faced in the past.
Volatility position sizing requires extensive knowledge of market volatility, as it solely relies on the volatile condition of the underlying asset.
When you use this position sizing strategy, you match the asset’s volatility condition to the amount you intend to risk on a specific trade.
Incorporating this strategy into your position sizing system ensures a safe trading account during highly volatile conditions.
Having a consistent reference about the sizes of your position is integral to assessing the effectiveness of your trading system, including set-ups, strategies, and risk management techniques.
Moreover, it helps you understand how your trade affects your capital negatively. It could be because you overexpose your capital to risk.
Journaling your position sizing guides you in avoiding positions that are too large compared to your capital. If the market moves against your overexposed trade, there’s a high chance of financial ruin.
Ultimately, it helps you understand whether you’re already capable and comfortable of upscaling your position sizes.
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