Trading Risk Management: How to Calculate the Right Position Size

In this post, we'll look at how to calculate position size, something you should know before you start trading. Why calculate position size in the first place?

Because trading always carries the risk of losing money. Calculating position size lets you manage trading risk systematically, so that a single bad trade doesn't cause a large loss.

Why You Should Calculate Position Size Before Trading

Proper risk management is essential in trading, no matter how much capital you have. If you don't manage risk properly, you can lose all your money in an instant. Money you spent weeks or even months earning can disappear just like that.

An important principle in trading and investing is not to make decisions based on emotions. Traders need to keep their emotions in check to minimize their influence on investment decisions. That's why it's a good idea to create a set of trading rules and stick to them.

The primary purpose of trading rules is to manage risk, and also to rule out unnecessary decision-making in advance. This way, you can avoid making hasty, impulsive decisions in the middle of a trade.

Key elements of trading rules include risk tolerance, capital exposure ratio, investment horizon, and position size. In this post, we'll take a detailed look at how to set the position size for an individual trade.

4 Steps to Determine Your Trading Position Size

To determine the position size for a trade, you need to go through the following 4 steps. They will help you set an accurate position size that fits your own trading.

1. Decide Your Trading Capital

First, you need to decide how much of your assets you can use for trading. How much will you put toward trading, and why?

For example, you might decide on trading capital of $3,000. The reason could be that you want to earn a 5% monthly return using one month's salary. And even in the worst case where you lose it all, it's only one month's salary, so it may not be a huge blow.

2. Decide Your Risk Tolerance

Have you decided how much capital to use for trading? Now you need to decide the maximum loss you're willing to accept on a single trade.

Many traders follow the 2% rule as a strategy for determining their trading position size. The 2% rule means committing to never losing more than 2% of your total account balance on a single trade.

For example, a trader with $3,000 in trading capital who follows the 2% rule would never lose more than $60 on a single trade.

However, if you trade frequently, like a scalper, or if you're a beginner, you might set a more conservative 1% rule instead. This means you won't lose more than 1% on any single trade.

3. Set Your Stop-Loss Point

The next thing to decide is your stop-loss point, the point at which your position is invalidated. Every trade has a chance of ending in a loss. So a good trader will prepare a stop loss to manage risk and limit losses.

For example, you could set a stop loss at a point -5% below the current market price. This means your position will close automatically if the market price falls -5% from where you entered.

4. Set Your Position Size

Now we can finally set the position size. So far, we've decided on $3,000 in trading capital and a risk tolerance of 2%. We've also decided to use a stop loss to close the position automatically if the price drops -5% from the current price.

The formula for calculating position size is as follows.

• Position size = Trading capital * Risk tolerance / Stop-loss point

Based on this, we can calculate the position size as follows.

• $1,200 = $3,000 * 0.02 / 0.05

Let's sum up. The position size the trader can use for this trade is $1,200. In other words, for a trader with $3,000 in total capital who accepts 2% risk, the position size that can withstand a -5% loss is $1,200.

Of course, position size can vary depending on the situation and your trading strategy. What happens if the stop-loss range becomes -10%? In that case, the position size gets smaller, as shown below.

• $600 = $3,000 * 0.02 / 0.1

Now the trader can withstand twice the loss compared to before. To do so, however, they need to take a smaller trading position. This way, they take on the same level of risk relative to their total trading capital.

Wrapping Up

When doing high-risk trading such as futures trading, it's a good idea to have your own strategy and principles well prepared. To avoid liquidation and keep a single trade from causing a big loss, it's best to set your trading position size before you start a trade.

If you think through what you need for setting your trading position size in advance, you can trade more steadily while protecting your capital.