The often overlooked question : How much should I buy or how do I trade size my positions to manage risk to 1%?
Most people place the same amount of capital on every single trade they place, such as “I always buy 1000 shares or bet £10 a point” this results in disaster and if you’re currently doing this, stop it and stop it now, otherwise you’re going to join the long list of losers and provide cannon fodder for the few of us who are doing the right way.
Remember this golden rule: For every trade you place, your trade size should vary and your risk should remain constant.
Lets explain this.
Imagine you have a £10,000 trading account. The amount you should risk on a trade risk should be no more than 1% , or as in this example £100.
So rather than plucking a number out of thin air, or always using a fixed amount, we must determine the trade size from both the trade risk (£100) and the stock chart :
Consider the following diagram:
This trade illustrates 3 important considerations of trade risk management .
Firstly, notice that the chart initially rises to 450 and falls as it meets resistance (perhaps the market feels the stock is overvalued at this level), as it starts to fall more selling is attracted and more sellers enter the market. At this point, the stock drops in value until it reaches a area of support at 300 (£3) (where the market deems that the stock is now undervalued and this attracts a fresh set of buyers into the market; bargain hunters; and the stock starts to move back up until it hits into resistance again, this time at 350 (£3.50). notice the sideways movement between 350 and 345 which has now set itself up. This is tight consolidation. As traders, we love these areas, as they provide us with the following, and relevant to the above example:
1) a decent reward potential – should this stock break out, through the 350 range, there are no barriers on the chart between 350 and 450 , as traders we can say that the potential rewards is 100 points –all going well. As traders we don’t know or really even expect the stock to run the full 100 points from the entry price breakout at 350…but from quick examination, we can see the reward outweighs the risk.
2) Now risk…we know that the entry price is above 350, the second point is where should our stop loss (your exit order if your trade fails) be placed? The answer to this question is generally just below support i.e. just behind the base of the consolidation at 345, in other words we are looking for the stock to run north from 350, but if it comes back we expect the 345 support to prop the stock up – should this level be breached – we don’t want to be in the trade.
3) Notice that the risk is only 5 points. So in terms of a ratio, our reward:risk is 100:5 or (20:1)…meaning for every £1 risked, there is a potential £20 to be made….good odds. 4) So now onto trade sizing – how much should be placed. If I was to place 10 trades like this and only 3 of them run into the right direction, and 7 trades run against me, then my net profit/loss is going to be extremely positive – despite losing on 70% of my trades.
5) How do I use this information to define my trade size? Simple: I divide my trade risk (remember that’s the 1% of £10,000 i.e. £100) by the risk on the trade…in this case it is 5 points. So, 100/5 = £20 . So I now know the maximum amount I can risk on this trade is £20 per point or if you are using cfds that’s 2000 shares.
6) Now if the trade runs in our favour, we stand to make a £2000 potential profit, for only £100 or 1% of our £10,000 account risked. Perfect.
