Position sizing refers to the number of units of a particular instrument bought or sold in a single transaction. It is essential for traders to better understand this concept as it gives them a good overview of the condition of their investment and its risk exposure.
Traders can improve their performance by utilizing position sizing, as it gives them a deep market insight, including the potential risks and gains from a particular trade. In this blog post, we take a closer look at what position sizing is, why it is important, and what are the best position sizing strategies.
What Is Position Sizing and Why Is It Important?
Position sizing is a critical component in trading and investing, particularly as part of an effective risk management strategy. It refers to deciding how much of your portfolio or capital you should risk on any single trade or investment.
In risk management, position sizing is paramount for several reasons. First, it protects traders from allocating too much capital to a single trade. This is important as no matter how certain a trade may appear, there is always a chance of loss. By limiting the amount risked on a single trade, traders ensure they can live to trade another day, even after a losing streak. This is crucial, especially for beginners who are entering the market with limited resources.
Next, position sizing allows traders to achieve more consistent results. Rather than staking random amounts based on emotion or intuition, traders who size their positions methodically tend to have a smoother earning curve and more predictable results. This, in turn, makes it easier to evaluate trading strategies and make necessary adjustments.
In summary, position sizing is a crucial risk management tool that ensures traders limit their exposure on each trade, helps achieve more consistent results, and provides a methodical approach to trading that can improve overall performance. Without proper position sizing, a trader’s capital is at greater risk, and their likelihood of long-term success significantly decreases. Therefore, understanding and employing effective position-sizing strategies should be a top priority for any serious trader or investor.
Position Sizing in Earn2Trade’s Funded Trader Accounts
Understanding position sizing is also essential for adhering to the trading rules of different platforms.
For example, in the context of Earn2Trade’s funded trading accounts, position sizing works in a slightly different way. Every trader must adhere to the maximum position size limit, which defines how many contracts one can have open at any time across all of their positions.
Some micro futures contracts, like MES, MNQ, and more, are exceptions to the rule and can be traded for up to ten contracts, all of which only count as a single one towards the maximum position size.
Check our dedicated article to understand further.
The Best Position-Sizing Strategies to Use
Every trader has their own unique style, objectives, and, most importantly, risk tolerance. As a result, they can choose different position sizing strategies that best complement their trading style and goals.
Some of the most popular position sizing strategies include:
- Percentage of capital – a fixed percentage of their capital (usually 1% or 2%) to place on every trade.
- Fixed dollar amount – a specific sum ($100, for example) to put on each trade. This strategy is another great way of keeping the risk level the same regardless of the position size.
- Kelly criterion – a mathematical formula developed by Jonh L. Kelly Jr. for sizing a bet. It enables traders to calculate how much to invest in a given asset to maximize future returns.
- Contract size – this strategy varies in its appliance, depending on the financial instrument being traded (stocks, futures contracts, etc.).
- Volatility-based – the trader adjusts the position size based on the current market volatility. When the market is experiencing high volatility, traders reduce their position size, and vice versa.
Percentage of Capital
This position sizing strategy relies upon dedicating a specific percentage of your trading capital for each trade. The benefit is that it keeps the risk exposure consistent and manageable regardless of the trade size or current account balance. This is particularly useful for new traders as it eases the process and helps avoid unnecessary risks.
There are free calculators and online tools which can help you discover the optimal position size based on your goals.
Let’s say you decide to invest 2% of your total trading capital ($10,000), meaning you would be investing $200 for each trade. In the case that your investment fails and you incur a loss, that loss would be limited to a maximum of $200.
As your capital grows, the fixed percentage will translate to higher bets. For example, if you made a couple of successful investments, and your capital has grown from $10,000 to $15,000, your investing percentage of 2% would now amount to $300 per trade.
It is essential to keep track of your percentage of capital invested and adjust it accordingly. For example, you might want to increase the percentage to increase profits and decrease it when your capital drops to prevent further losses and preserve the initial investment.
Fixed Dollar Amount
This position sizing strategy enables the trader to invest a predetermined amount per trade, disregarding the total capital (e.g., $100 per trade).
A positive aspect of this strategy is that it sets a defined limit on your losses per trade – in this case $100 per trade.
The fixed dollar amount strategy maintains the consistency of the risk exposure regardless of the price of an asset, or the size of the account. Risk management becomes easy, and the trader has complete control of the investments.
Kelly Criterion
Kelly Criterion is a mathematical formula developed to calculate how much capital to invest in a single trade based on the expected risk, reward, probability, and other factors. It was introduced in 1956 as a way to ease bet sizing and was primarily used in gambling. However, later on, it made its way into investment management.
Make sure to dive into the Kelly Criterion specifics and adjust it to your unique circumstances and preferred trading style.
To ease the process, you can use one of the multiple free Kelly Criterion calculators available online.
Contract Size
The contract size strategy for position sizing is a straightforward approach used primarily in futures and options trading. It works on the basis of a fixed number of contracts or lots per trade.
In this strategy, the trader decides on the number of contracts they wish to trade for each position. This number remains the same for all trades and doesn’t change based on the trader’s capital, the market’s volatility, or other factors. This is a simple and easy-to-understand strategy, and it’s popular among beginners or traders with smaller accounts.
For instance, if a trader decides to trade two contracts of a specific futures, they will buy or sell two contracts each time they make a trade, regardless of the contract’s price or the trade’s total value.
However, the contract size strategy doesn’t factor in the risk associated with each trade. Two contracts in a highly volatile market could represent a significantly larger potential loss than two contracts in a less volatile market. Also, this approach doesn’t adjust the size of the position relative to the size of the trader’s account, which can lead to disproportionate losses if a trade goes wrong.
For this reason, while the contract size strategy can be useful in certain circumstances, it’s often combined with other strategies or risk management techniques to ensure the trader is not exposed to excessive risk. Traders often use stop-loss orders, for example, to limit their potential losses on each trade, or they may adjust the size of their position based on the volatility of the market or the size of their trading account.
Volatility-Based
The volatility-based strategy for position sizing in trading is a method that adjusts the size of a trading position based on the market’s volatility. It acknowledges that not all trading instruments are created equal – some are more volatile than others. Therefore, it aims to standardize the level of risk across various trades and securities.
The core idea behind the volatility-based strategy is simple: trade less when the market is more volatile and trade more when the market is less volatile. This is based on the assumption that when markets are volatile, the price swings are larger, and therefore, the risk is higher.
In this approach, a trader might use a volatility indicator like Average True Range (ATR) or standard deviation to quantify the market’s volatility. Once the volatility is calculated, it’s used to adjust the position size.
For instance, if an instrument is highly volatile, the trader might decide to reduce the number of units they’re buying to maintain their risk at a manageable level. And vice-versa.
In a nutshell, by adjusting the position size based on market volatility, traders can potentially reduce their exposure during volatile market periods and increase it when the markets are less volatile.
Position Sizing Tips & Tricks
Make sure to properly identify the most suitable entry and exit points for your trades. That way, you will be able to better calculate the risk and reward of each move. Learn more here.
Also, set your stop losses to be able to automatically exit the trade when it reaches levels that you deem unprofitable and thus prevent cascading losses.
Consider utilizing trailing stops since they are a useful tool to protect your investment when it has turned profitable. You can do this by locking in your profits while simultaneously allowing the trade to develop further in a positive direction while protecting your gains at the same time.
The most important tip is tailoring your position size and strategy in accordance with every trade. By doing so, you take into account the market conditions and volatility, and in combination with the desired amount of risk, you can tailor your position size to maximize profits. Be consistent and regularly review your position sizes, so that you can adjust them based on the prevailing market conditions.
Conclusion
In conclusion, position sizing plays an instrumental role in successful trading and risk management. It offers traders the opportunity to maximize profits while limiting potential losses. Whether it’s a fixed-dollar amount, a percentage of capital, contract size, or a volatility-based approach, each strategy has unique strengths and is suited for different trading styles and risk tolerance levels.
Understanding and implementing the proper position sizing strategy can significantly enhance your trading performance, fortify your portfolio against market volatility, and help you navigate the trading journey with a clear and focused game plan.
