How to Determine Proper Position Size When Trading – Any Trade, Any Market
A crucial element of trading success is taking the proper position size on each trade. Position size is how many shares you take on a stock trade, how many contracts you take on a futures trade, or how many lots you trade in the forex market. Position size is not randomly chosen, nor based on how convinced you are a trade will work out. Rather, position size is determined by a simple mathematical formula which helps control risk and maximize returns on the risk taken.
There are three steps to determining the proper position size, and it works for any market. We will then look at couple alternative position sizing techniques for specific circustances.
Position Sizing Strategy Step 1 – Determine Account Risk
No matter if your account is large or small—$1000 or $500,000–a single trade shouldn’t put more than 1% of your trading capital at risk. On a $1000 account, don’t risk more than $10 on a trade, which means you’ll need to trade a micro forex account. If your account is $500,000, you can risk up to $5,000 per trade.
While it’s not recommended, if you risk up to 2% of your account per trade, then on a $25,000 account you can risk $500 per trade. On a $50,000 you can risk $1000, and so on.
Why only 1% risk? Even great traders can experience a string of losses. But if you keep risk below 1% per trade, even if you lose 10 trades in a row (should be very rare!) you still have almost all your capital. If you had risked 10% of your account on each trade, and lost 10 in a row, you’d be a wiped out. Also, even with risking 1% (or less) on each trade you can still make great returns.
Only risking 1% also helps avoid the disaster scenario where you end losing much more than anticipated. A stop loss order doesn’t guarantee an exit at the price we specify. In a volatile move, or an overnight gap in price, we could lose substantially more than 1% (called slippage). If we only risk 1%, usually those devastating moves only result in a several percentage drop in equity which is easy to recover. Had you risked 10% on the trade though, such a move could wipe up half or nearly all your capital.
If your account is larger, you may wish to risk less than 1%. In that case, choose a fixed dollar amount that is less than 1% and use that as your account risk. A $1 million dollar account can risk $10,000 per trade, but you may not want to risk that much (not to mention, liquidity becomes an issue with bigger position sizes). Instead, you may opt to only risk $1,000, for example. $1,000 is less than 1% so it’s a suitable figure, and is the account risk ($) which you’d use in step three.
What is 1% of your account, in dollars? That’s your account risk, and it’s how much you can risk on one trade.
Position Sizing Strategy Step 2 – Determine Trade Risk
To determine our positions size we must set a stop loss level. A stop loss is an order that closes out the trade if the price moves against us and reaches a specific price. This order is placed at a logical spot which is out of range of normal market movements, and if hit, let’s us know we’re wrong about the direction of the market (at least for the moment).
Figure 1 shows a trade example in the EURUSD. The price climbs into a former resistance area, but then stalls out, moving sideways then dropping. This triggers a short trade (a method covered in the Forex Strategies Guide eBook). The entry price of the short is 1.14665 and we place a stop loss at 1.15045. This results in a trade risk of 38 pips.
You’ll need the trade risk in order to move onto the next step in determining proper position size. For forex, we measure trade risk in pips, in the stock market in cents or dollars, and in the futures market we measure it in ticks or points.
Assume you buy a stock at $9.50, and place a stop loss at $9.40. The trade risk is $0.10.
If trading a futures contract, how many ticks or points are there between the entry and exit price? If trading the E-mini S&P 500 (ES), and you buy at 1220 and place a stop loss at 1210, that’s a 10 point (or 40 tick) trade risk.
Position Sizing Strategy Step 3 – Determine Proper Position Size
You now have all the information you need to calculate the proper positions size for any trade. You know your account risk, and you know your trade risk. Since trade risk will fluctuate on each trade, and your account risk will also fluctuate over time as your balance changes, your position sizes will be different from one trade to the next, usually.
To calculate position size, use the following formula for the respective market:
Stocks: Account Risk ($) / Trade Risk ($) = Position size in shares
Assume you have a $100,000 account, which means you can risk $1000 per trade (1%). You buy a stock at $100 and a place a stop loss at $98, making your trade risk $2.
Stocks: $1000 / $2 = 500 shares.
500 shares is your ideal position size for this trade, because based on your entry and stop loss you are risking exactly 1% of your account. The trade costs you 500 shares x $100 = $50,000. You have enough money in the account to make this trade, so leverage is not required.
Forex: Account Risk ($) / (Trade Risk in pips x Pip Value) = Position size in lots
Assume you have a $5,000 account, which means you can risk $50 per trade. You buy the EURUSD at 1.1500 and place a stop loss at 1.1420, making your trade risk 80 pips. To complete the formula you’ll need to know the pip value of all pairs you trade. For the EURUSD it is always the same if you have a USD account: $0.10 for a micro lot, $1 for a mini lot, and $10 for a standard lot. For some other pairs it is different though. See Calculating Pip Value in Different Forex Pairs and Account Currencies.
Forex: $50 / (80 pips x $0.1) = $50 / $8 = 6.25 micro lots. Micro lots are the smallest trading lot with most brokers, so we can’t buy a partial lot. Therefore, we would round our position size down to 6 micro lots.
We know it is 6 micro lots because we used the pip value of a micro lot into the formula. To get the position size in mini lots, input $1 for the pip value instead. Doing so produces a position size of 0.625 mini lots, which is the same as 6.25 micro lots. The trade costs you $6,000 to make though (the value of 6 micro lots). To take the trade requires leverage.
Futures: Account Risk ($) / (Trade Risk in ticks x Tick Value) = Position size in contracts
Assume you have a $13,000 account, which means you can risk $130 per trade. You buy an E-mini S&P 500 (ES) contract at 1210.00 and place a stop loss at 1207.50, putting 10 ticks at risk (there are 4 ticks per point). You need to know the tick value of the contract you’re trading in order to determine the proper position size. For ES, each tick is worth $12.50.
Futures: $130 / (10 ticks x $12.50) = $130 / $125 = 1.04, or 1 contract. Holding a one contract position only costs about $500 in intraday margin (day trading) with many US brokers. If you hold overnight you’ll be subject to initial and maintenance margin. There is enough funds in the account to day trade this position or hold it overnight.
The Equal Dollar Amount Approach
I use another position sizing technique, typically in non-margined accounts like retirement accounts, etc.. Typically I am only trading stocks in these accounts.
In these types of accounts, I tend to accumulate longer-term trades, lasting weeks to months, or even years. Therefore, I don’t want to put all my capital in only a handful of trades, which often happens if using the 3-step approach discussed above.
Instead, I divide the account by 10 or 20, thus putting 5% or 10% in each stock I decide to trade. On a $200,000 account, I may put $20,000 into each stock. If there are a lot of possible trades out there, I may diversify a bit more and cut my account up into 20 positions, putting $10,000 in each.
Let’s assume I am putting 5% of my capital into each stock. On $200,000 account, that means buying $10,000 worth of stock on each trade. That doesn’t mean I am willing to lose all $10,000. That is just how much stock I buy. If the stock price is $25, I can buy 400 shares. If the stock price is $100, I buy 100 shares, and so on.
On each position, I still put a stop loss and control my risk. In order to take the trade, I need to reasonably expect that I can make at least make 2:1 on my risk. Typically I will want 3:1 or 4:1.
This approach is simpler for many people to understand. Buy a fixed amount of stock on each trade, and then set the stop loss wherever it should be for that trade. Make sure the profit potential justifies the risk. This is what my Stock Swing Trading Course is all about.
Equal Position Approach
I only use the equal position approach when day trading the same asset for extended periods of time. Whether it is a stock, forex pair, or futures contract, if I am trading it all the time I often use a default position size. Say 1000 or 2000 shares in a stock, or 10 contracts/lots.
This default amount, whatever you choose, shouldn’t expose your account to a more than 1% loss on each trade. While the odd trade may produce a bit more risk (and profit) than average, another trade will likely produce less, so over many trades it evens out.
With lots to think about in a fast moving market, a default position size is one less thing to worry about.
If it is a very volatile day, you will want to reduce your default size. If it is a very quiet day, you may want to up it slightly (or not trade). Therefore, a default position size doesn’t mean you don’t think about position size anymore. You still have to, you just don’t need to adjust it every trade.
Some assets work better with a default position size than others. Assets that tend to have similar volatility each day work well with a default position size. If it seems like you stop loss levels are very different on each trade, then a default position size won’t work well.
Proper Position Sizing Strategy – Final Word
The three-step method gives you the ideal position size for any market and any trade. When day trading you’ll need to quickly calculate your position size as you spot trades. Planning ahead will help in this regard, as discussed in How to Day Trade Forex in 2 Hours or Less. With a bit of practice, even when making trades on the fly, you should be able to nail the position size on your day trades every time. If swing trading, you have more time, so there’s no excuse for taking the wrong position size.
The method works for swing traders and day traders. Depending on which market you trade, master the formula. If you trade forex or futures, know your tick and pip values (or have them written down).
The equal dollar amount method works great for investor or swing traders in unleveraged accounts. There is less math involved because we always know how much stock (in dollars) we can buy. Then, we just set our stop loss and target on each trade.
Equal position size works for day traders who know the asset they are trading very well, and find that the distance to the stop loss on most of their trades is quite similar.
All these methods are work, although you may find one works better for your particular circumstance.