STEP-7: Proper position sizing
We have kept the best for last, because this is where most traders really screw up. Configuring your correct EXPOSURE.
It is a well-known fact in trading circles and best practices that you should risk no more than 2-4% of your trading capital on any one trading idea. It is important to understand that this number is NOT the distance to your stop-loss!
When risking only 2-4% of your capital on each trading idea, you make it mathematically impossible to blow your account! Also, it forces you to open multiple trades and thus spread your risk as opposed to going all-or-nothing on a single trade idea that could blow-up.
With the 2-4% rule, the bigger your account grows, the more you can expose on each trade and the smaller your account gets, the less you can put into the market. It’s thus theoretically impossible to go bankrupt!
So, let’s say you have R100,000 to trade with. That means each trade can lose no more than R2,000 to R4,000. How will we incur that loss? By the share pricing closing below our stop and forcing us to ABORT before we could make any profits.
How much percent loss could we land up making by this happening?
- The share must fall 7.5% in our example to close below the STOP
- We will probably have to budget slippage of 1% as we’re not guaranteed to exit at our exact stop level if the share crashes through the stop
- We need to budget for trading costs, let’s say 0.5% to enter and 0.5% to exit
So, we have 7.5% + 1.0% + 0.5% +0.5% = 9.5% in budgeted losses when the trade goes sour on us. When this happens, we’re not allowed to lose more than R2,000 to R4,000.
This means we can place a trade into the market of no more than:
(R2,000 to R4,000)/9.5% = R21,052 to R42,105
We cannot spend more than the above amounts on our ANGGOLD trade!
Even if you are trading with leverage through Contracts for Difference (CFD’s), you must ensure you only put down that margin that does not expose you to more than these amounts we have just calculated. You laugh – people go and put in R21,000 in margin, exposing themselves to R200,000 in the market! Leverage is the undoing of many a trader – not because of the leverage itself, but because clients tend to over-expose themselves in leveraged environments.
In the final installment next week, we put it all together on one page as a summary.
Dwaine van Vuuren
RecessionAlert, Sharenet Analytics
Dwaine van Vuuren is a full-time trader, global investor and stock-market researcher. His passion for numbers and keen research & analytic ability has helped grow RecessionALERT.com (US based) and PowerStocks Research (now Sharenet Analytics) into companies used by hundreds of hedge funds, brokerage firms, financial advisers and private investors around the world. An enthusiastic educator, he will have you trading and investing with confidence & discipline.