A key component of responsible and profitable trading is sound risk management. In a nutshell, risk management refers to setting stop-losses and calculating the appropriate position size that maximizes your potential for gains and ensures you don’t lose more than you can afford to lose.
Risk management = Stop Loss + Calculated Position Size
The benefit of trading with calculated position sizes (and not a random number) is that you always know how much you stand to lose if the trade goes against you. This number will end up being a percentage of your trading account.
Practicing risk management will keep you in the game much longer since your risk, and therefore your position sizes will decrease when you are on a losing streak. This is especially helpful when you are still learning the ropes.
How much are you willing to risk?
If your account size is ZAR3000 and your risk appetite is 2%, you should only lose ZAR60 if your trade goes in the opposite direction. If you are more confident of the trade you can choose to use 3% risk or even more. Similarly, if you are unsure then use only 1%.
Now, if you lost that first trade then your account balance will be reduced to ZAR2940. With your risk still being 2%, this system will now only allow you to lose R58 in your next trade.
This decrease in risk amount will likely also have an effect on your position size. With all other values being equal, the lower your account balance the lower your position size ends up being.
Calculating position size
In order to calculate position size for your next trade you will need to know four numbers:
- The current size of your trading account
- How much are you willing to risk (most traders trade between 1 – 3% risk depending on the setup)
- What is your entry price
- Where do you plan to place your stop loss
You can then use this formula to do the calculation, or use my position size calculator.
[(Account size * risk %) / (Entry price – Stop Loss)] * Entry Price