• Position sizing refers to the number of units invested in a particular security by an investor or trader. An investor’s account size and risk management should be taken into account when determining appropriate position sizing.

    No matter how big your portfolio is, it’s better to exercise proper risk management. Otherwise, you may quickly make mistakes and suffer notable losses. Valuable months of progress can be wiped out by a single poorly managed trade.

    A fundamental purpose when it comes to trading or investing is to avoid making emotional decisions. You must have the ability to keep them in check so that they don’t affect your trading and investment decisions. This is why you need to come up with sets of rules that you can follow during your investments and trading.

    Let’s call these rules your trading system. The purpose of this system is to manage risk, but meanwhile, eliminating unnecessary decisions. This way, when the time comes, your trading system stops you to make hasty and impulsive decisions.

    When you’re establishing these systems, you’ll have to consider a few things. What’s your investment horizon? What’s your risk tolerance? How much capital can you risk? We could think of several other questions, but in this article, we’ll focus on one particular aspect – how to size your positions for individual trades.

    To do that, first, we must determine how big your trading account is, and how much of it you can risk on a single trade.

    How to determine account size

    While this may look like a simple, even redundant step, it’s a valid consideration. Especially when you are new to this space, it may help to allocate certain portions of your portfolio to different strategies. This way, you can more accurately track the progress you’re making with different strategies, and reduce the chance of risking too much as well.

    For instance, let’s say you believe in the future of Bitcoin and have a long-term position tucked away on a hardware wallet. The best method is not to count that as a part of your trading capital.

    In this way, determining the account size is easily looking at the available capital that you can allocate to a specific trading strategy.

    How to determine account risk

    The second step is to determine your account risk, which includes deciding what percentage of your available capital you want to risk on a single trade. 

    The 2% rule

    In the traditional financial sphere, there’s an investing strategy called the 2% rule. It means a trader shouldn’t risk more than 2% of their account on a single trade. We’ll go over what that means precisely, but first, let’s adjust it to be more suitable for the volatile crypto markets.

    The 2% rule is a strategy suitable for investment styles that typically involve entering only a few, longer-term positions. Moreover, it’s normally tailored to less volatile instruments than cryptocurrencies. If you’re a more active trader, particularly if you’re starting, it could be lifesaving to be even more conservative than this. In this case, let’s modify this to be the 1% rule instead.

    So this rule says you shouldn’t risk more than 1% of your account in a single trade. Does this mean that you only enter trades with 1% of your available capital? Not! It only means that if your trade idea is wrong, and your stop-loss is hit, you’ll only lose 1% of your account.

    How to determine trade risk

    So, how do we determine the position sizing for a single trade?

    We look at where our trade idea is invalidated.

    This is a crucial consideration and applies to most strategies. When it comes to trading and investing, losses are always a part of the game. They’re a certainty. These are a game of probabilities – and the best traders aren’t always right. Some traders might be wrong much more than they are right and still be profitable. It all comes down to proper risk management, having a trading strategy, and sticking to it.

    As such, every trade idea must have an invalidation point. This is where we say: “our initial idea was wrong, and we should get out of this position to mitigate more losses”. In other words, it is where we place our stop-loss order.

    The way to determine this point is completely based on individual trading strategy and the specific setup. The invalidation point can be based on technical parameters, like a support or resistance level. It could also be based on indicators, a break in market structure, or something else entirely.

    There isn’t a one-size-fits-all approach to determining your stop-loss. You must decide for yourself what strategy suits you the best and determine the invalidation point based on that.

    How to calculate position size

    So, now, we have everything we need to calculate position size. Let’s say we have a $5000 account. We’ve decided that we’re not risking more than 1% on a single trade. This means that we must not lose more than $50 on a single trade.

    So far we’ve done our analysis of the market and have determined that our trade idea is invalidated 5% from our initial entry. In effect, when the market goes against us by 5%, we exit the trade and take the $50 loss. It means 5% of our position should be 1% of our account. 

    • Account size – $5000
    • Account risk – 1%
    • Invalidationpoint (distance to stop-loss) – 5%

    The formula to calculate position size is like this:

    position size = account size x account risk / invalidation point

    position size = $5000 x 0.01 / 0.05

    $1000 = $5000 x 0.01 / 0.05

    The position size for this trade will be $1000. So by following this strategy and exiting at the invalidation point, you may mitigate a much larger potential loss. To properly do this model, you’ll also have to calculate the fees you’re going to pay. Additionally, you should think about potential slippage, particularly if you’re trading a lower liquidity instrument.

    To show how this works, let’s increase our invalidation point to 10%, with everything else being the same. 

    position size = $5000 x 0.01 / 0.1

    $500 = $5000 x 0.01 / 0.1

    In this case, our stop-loss is now twice the distance from our initial entry. So, if we want to risk the same $ amount of our account, the position size we can take is cut in half.

    Closing thoughts

    Calculating position sizing isn’t based on some arbitrary method. It involves determining account risk and looking at where the trade idea is invalidated before entering a trade.

    Another important aspect of this strategy is execution. Once you’ve determined the position size and the invalidation point, you shouldn’t overwrite them once the trade is live. This strategy needs practice, but it’s certainly worth that.

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