Today’s Trading Lesson From TradingMarkets

But money management is the most
important self-imposed rule in the business of trading. One very important
component of money management that I’ll focus on in this lesson is “position
sizing.”

There are two aspects of position
sizing that I’ll touch on. One is psychological and the other is the “how-to”
aspect of it. First, let me deal with the psychological component. A popular
piece of advice being handed out these days to beginning traders is to gain
experience by using “paper trading.” That is, you trade for a while without
using real money, going through the motions of buying and selling. You apply
whatever trading strategy you’d be using if you were trading for real. Advising
beginners to paper trade is, in my opinion, one of the worst things you can do.
It makes you overconfident. It doesn’t take into the account the powerful
emotions that cloud your thinking when you’re using real money. We all trade
because we love money and what money can do for us. Feelings of intense pain and
pleasure are associated with the losses and gains we experience as traders.
These are the emotions that make us do dumb things even when we know better.

So my first
piece of advice is this:

Adjust your position size to a
level that enables you to think clearly and rationally.

This can take some experimentation,
but I’d venture to guess that adopting this simple rule would benefit scores of
traders.

Now — let’s say you want to put this
into practice. How do you do it? If you’ve thought in the back of your mind that
position sizing was somehow important, but only had a vague sense of what to do
next, I will now give you a tool that you can use to quantify your risk before a
trade is entered.

Sizing allows a trader to adjust
the amount of money that he is willing to lose in a worst-case scenario in any
market. It is a plan to limit the
inevitable loses in trading. The method I
will teach you is “% risk into entry/exit.”  The “% risk” refers to the
portion of money from your total amount of available money that you are willing
to lose or put at risk. The terms “entry/exit” refers to the price at which you
plan to enter the trade and the exit price
where you would place your stop loss order…the price at which you think you
would not want to be in the trade any longer.

The “%risk into
entry/exit” uses an entry price, a stop loss price, and the difference between
the two expressed as a dollar amount (1 5/8 = $1.62), which is divided into the
total dollar amount a trader is willing to lose, or % risk. Most sources suggest
risking no more than 2% of your total amount of trading capital on any one
trade. As stated earlier, you should decide
what this number should be on the basis of how you will be affected
psychologically. The “% risk into entry/exit “ is a method used under the
most ideal market conditions of liquidity and lesser volatility. 

Using this formula to limit your position
size will keep your risk exposure under control. It will prevent you from
deciding how many shares to buy purely on the basis of emotion or feel. Without
this criteria in place, you are most likely to be overly optimistic about your
odds of success and buy more shares than you should.

So let me take you through the steps
you’d go through if you were applying this formula. Let’s say you had a total of
$14,800 to trade with, and you wanted to risk no more than 2% on any given
trade. That risk amounts to $296. To properly size the trade, you would subtract
the entry price from the stop loss price and divide that amount into $296. For
example, we have a trade where we will enter long in stock XYZ at $42 5/8 and,
if filled, we’ll place a stop loss at 41 15/16. The difference between the entry
and stop loss is 11/16 ($0.68 cents). Doing the division: ($296/$0.68 =
435) tells us we should buy 435 shares. Finally, as a matter of course in
sizing, we would round DOWN this number to 400 shares. These calculations do not
include commissions and slippage, however, the astute trader can minimize these
costs by choosing a very liquid stock and a low-commission brokerage.

Does the logic make sense to you? It will
if you play with the numbers a bit. If you loosen your stop and put it farther
below your entry price, but keep your total risk at 2%, the formula will make
you buy fewer shares. If you tighten your stop and put it closer to your entry
price, you’ll wind up buying more shares.

What this formula does is give you an
objective way of determining the number of shares you should buy if you have a
specific percent of your total trading capital that you want to risk. It allows
you to play out “what if” scenarios