Introduction
No matter the size of your portfolio, you need proper risk management. Otherwise, you could suffer considerable losses in a short time. A single poorly managed trade can end up derailing weeks or even months of progress.
A fundamental objective when it comes to trading or investing is to avoid decisions influenced by emotions. As there is a financial risk, emotions have enormous weight. You need to keep them under control so that they do not affect your trading and investment decisions. This is why it might be a good idea to create sets of rules to follow during your trading activities.
Let's call these rules your trading system. The purpose of this system is to manage risks, but beyond that, it is very important to help eliminate unnecessary decisions. This way, when the time comes, your trading system will prevent you from making hasty and impulsive decisions.
When establishing this system, you need to consider a few things. What is your investment horizon? What is your risk tolerance? How much capital can you risk? We could think of many other factors, but in this article, we will focus on one specific aspect – how to size your positions for individual trades.
To do this, first, we need to determine the size of your trading account and how much of it you are willing to risk on a single trade.
How to determine account size
While this may seem simple and even redundant, it is a valid consideration. Especially for beginners, it can help to allocate parts of your portfolio to different strategies. Therefore, it is possible to more accurately monitor the progress of different strategies and reduce risks.
For example, let's say you believe in the future of Bitcoin and have a long-term position hidden in a hardware wallet. It may be best not to consider this amount as part of your trading capital.
Determining account size is simply looking at the available capital you can allocate to a specific trading strategy.
How to determine account risk
The second step is to determine the risk of your account. This involves deciding what percentage of your available capital you are willing to risk on a single trade.
The 2% rule
In the traditional financial world, there is an investment strategy called the 2% rule. According to this rule, a trader should not risk more than 2% of his account on a single trade. We'll look at exactly what this means, but first, let's make adjustments to adapt the rule to volatile cryptocurrency markets.
The 2% rule is a strategy suitable for investment styles that typically involve only a few long-term positions. Furthermore, this rule is generally used for less volatile markets than cryptocurrencies. If you are a more active trader and, especially, if you are starting out, it may be interesting to be even more conservative. In this case, we will change the rule to the 1% rule.
This rule states that you should not risk more than 1% of the account value on a single trade. Does this mean you only trade with 1% of your available capital? Of course! This just means that if your trading idea is wrong and your stop-loss is hit, you will only lose 1% of the account value.
How to determine trade risk
So far, we have determined the account size and risk. And how do we determine position size for a single trade?
We analyze where our trade idea is invalidated.
This is a very important consideration that applies to almost all strategies. When it comes to trading and investing, losses will always be present. It's a game of probabilities – not even the best traders are always right. In fact, some traders make more mistakes than they get right and still manage to maintain profitability. How is this possible? It all comes down to proper risk management, defining and maintaining a trading strategy.
Therefore, every trade idea must have an invalidation point. This is where we say: “the initial idea was wrong and we must exit this position to avoid additional losses”. Thinking on a more practical level, this is the point where we place our stop-loss order.
The way to determine this point is based on the individual trading strategy and specific setup. The invalidation point can be based on technical parameters such as a support or resistance region. But it can also be based on indicators, a disruption in market structure, or something else entirely.
There is no single approach to determining your stop-loss. You will have to decide which strategy best suits your style and then determine the invalidation point based on that.
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How to calculate position size
Now we have all the necessary ingredients to calculate position size. Let's say we have a bill for $5000. We define that we will not risk more than 1% on a single trade. In other words, we cannot lose more than $50 on a trade.
Assuming we have done our market analysis, we determine that our trade is invalidated by 5%, in relation to our entry value. In other words, when the market moves against us by 5%, we exit the position and assume a loss of $50. In other words, 5% of our position represents 1% of our account value.
Account size – $5000
Account risk – 1%
Invalidation point (distance from stop-loss) – 5%
The formula for calculating position size is as follows:
position size = account size x account risk / invalidation pointposition size = $5000 x 0.01 / 0.05$1000 = $5000 x 0,01 / 0,05The position size for this trade will be $1000. By following this strategy and exiting the position at the invalidation point, you can avoid a much larger loss. To properly exercise this model, you will also have to take into account the fees to be paid. Additionally, you should think about the possibility of slippage, especially if you are trading with less liquid instruments.
To illustrate how this works, let's increase our invalidation point to 10%, keeping everything else unchanged.
position size = $5000 x 0.01 / 0.1$500 = $5000 x 0,01 / 0,1Our stop-loss is now twice as long as the entry value. Therefore, if we intend to risk the same amount of our account, the size of the position we can take is halved.
Final considerations
Position size calculation is not based on any arbitrary strategy. Before entering a trade position, you need to determine the account risk and check where the trade idea is invalidated.
An equally important aspect of this strategy is execution. Once you determine the position size and invalidation point, you should not change them after the trade is active.
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