The effective management of risk is a key component to any trading strategy. If you approach any market without having included strategies to address risk and loss, then the most likely outcome will be uncontrolled loss. Risk management is your survival tool.
Position Sizing (the calculation of the value of your trade) enables you to implement risk control aligned to your tolerance of loss (we all have a different level of tolerance), your available trading capital and the trading style you are using. It also enables you to compare potential trade loss relative to gains as you can calculate your outcomes to your exits.
Let’s look at some simple examples of different Position Sizing calculations and how they affect results. For each example the same following trade conditions will be used:
Trading Capital $4,000
Buy BTC at $400
Stop Loss at $350
Profit Exit at $500
1) Fixed $ Risk.
In this approach, you set a fixed $ amount you are prepared to lose in any trade. Let’s say I am prepared to lose a maximum of $250. Calculation: $400-$350=$50 (loss per BTC). $250/$50=5(Buy 5 BTC at $400).
Position size is $2,000 = 5 BTC.
Potential Risk = $250
Potential Gain = $500-$400=$100 x 5=$500
2) Fixed percentage of capital risk.
In this approach, you set a fixed percentage of your capital as a risk. Let’s say 2%. Calculation: $4,000×2%=$80 (risk will be $80). $80/$50=1.6 (Buy 1.6 BTC at $400).
Position size is $640 = 1.6 BTC
Potential Risk = $80
Potential Gain = $500-$400=$100*1.6=$160
3) Full capital used in any trade.
In this approach, you just buy as much as possible of your capital. Calculation: $4,000/$400 = 10 (Buy 10 BTC at $400).
Position size is $4,000 = 10 BTC
Potential Risk = $50×10=$500
Potential Gain = $100×10=$1,000
You might think, ‘”I’ll just use the approach that gives me the biggest potential profit per trade”. However, that ignores the impact of loss (or drawdown) on your capital. Imagine you have a losing streak of five trades in a row (can easily happen). Look at each of the above approaches and calculate how much $ loss that equates to (the differences are significant). By looking at both loss and profit potential and tailoring the numbers, you can adjust any of these examples to suit your trading.
Finally, we encourage interaction and your input, perhaps you would like a certain topic covered, or you might have a view on one of the topics discussed. Whatever it may be please feel free to add your comments.
By Michael Whitehorn for CEX.IO