the introduction

Regardless of the size of your investment portfolio, you must carefully implement a risk management strategy, otherwise your account may quickly collapse and you may suffer huge losses. You can lose weeks or even months of gains due to a single trading operation that you did not study well.

One of the primary goals in trading or investing is to avoid emotional decisions. When it involves financial risk, emotions play a big role. You must learn to control these feelings so that they do not affect the trading and investment decisions you make. That's why it's helpful to establish a set of rules that you can follow in your trading and investing activities.

We will call these rules the trading system. The purpose of this system is to manage risks, as well as to help eliminate unnecessary decisions, which is no less important than risk management. This way, when the right time comes, the trading system will prevent you from making hasty and impulsive decisions.

When developing trading systems, you need to take into consideration a few things: What are your investment horizons? What is your risk tolerance? How much capital can you risk? We can think of many other points, but in this article we will focus on one specific aspect – how to size your positions in single trades.

In order to do this, you first need to determine the size of your trading account, and how much you are willing to risk from this account in a single trade.

How to determine the account size

This step may seem simple and repetitive to you, but it is important. When you are a beginner in the world of trading, it may be beneficial for you to allocate certain shares of your investment portfolio to different strategies. This way, you can more accurately track the progress you make with each strategy, and also reduce the chances that you will risk too much.

For example, let's say you believe in the future of Bitcoin, and you purchase coins for long-term holding on a hardware wallet. It is better not to count the value of these currencies as part of the trading capital.

In this way, determining account size becomes simply a matter of looking at the available capital you can allocate to a particular trading strategy.

How to determine account risk

The second step is to determine the account risk. This involves deciding what proportion of your available capital you are willing to risk on a single trade.

2% rule

In the world of traditional financial investments, there is an investment strategy called the 2% rule. According to this equation, a trader should not risk more than 2% of his account in one trade. We'll go over what exactly this means, but first we'll tweak the equation to make it more suitable for volatile cryptocurrency markets.

The 2% rule is a strategy suitable for investment styles that typically involve only a few long-term trades. They are also intended for financial instruments that are less volatile than cryptocurrencies. If you are an active trader, especially if you are just starting out, it may save you risk to be more conservative with your trades than this percentage, in which case we will modify the formula to the 1% rule.

This formula states that you should not 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? of course not! It just means that if your idea is wrong, and you hit the stop loss level, you will only lose 1% of your account.

How to determine trading risks

So far, we have determined the account size and account risk, so, how do we determine the position size for a single trade?

You have to look at the level at which you will cancel the trade.

This is an important consideration and applies to almost all trading strategies. When we talk about trading and investing, losses will always be part of the equation. In fact, it is a definite possibility. Trading is a game of probabilities – and even the best traders sometimes get it wrong. In fact, some traders make more mistakes than they get right, and still make profits. How is this possible? It boils down to carefully managing risk, developing a trading strategy and sticking to it.

Therefore, every trade has to have a cancellation point, which is the point at which you say: “My initial idea was wrong, and I should exit this trade to avoid further losses.” In more practical terms, it means the level at which you will place a stop loss order.

The method for determining this point is based entirely on the individual trading strategy and specific settings. The cancellation point can be determined based on technical metrics such as the support or resistance area. It can also be determined based on indicators, a change in market structure, or something completely different.

There is no one-size-fits-all approach when setting a stop loss level. You will have to decide for yourself which strategy is suitable for your trading style and set the cancellation point accordingly.

How to calculate deal size

Well, now we have all the components we need to calculate the deal size. Let's say your trading account is worth $5,000, and we have specified that we will not risk more than 1% per trade. This means that you cannot lose more than $50 per trade.

Let's say we have done a market analysis and determined that we will cancel the trade when the value drops 5% below the entry level. That is, when the market goes against the direction we want by 5%, we will exit the trading process and bear a loss of $50. In other words, 5% of the trade should equal 1% of the account.

  • Account size – $5,000

  • Account risk – 1%

  • Breakout point (distance to stop loss) – 5%

The equation for calculating the deal size is as follows:

Transaction size = account size * account risk / cancellation point

Transaction size = $5000 * 0.01 / 0.05

$1000 = $5000 * 0.01 / 0.05

So, the transaction size for this trade will be $1000. By following this strategy and exiting at the point of cancellation, you may avoid much larger potential losses. To apply this model optimally, you will need to also take into account the fees you will pay. Also, you should consider possible slippage, especially if you are trading a financial instrument with low liquidity.

To illustrate how this model works, let's raise the cancellation point to 10%, keeping all other factors the same.

Transaction size = $5000 * 0.01 / 0.1

$500 = $5000 * 0.01 / 0.1

The stop loss level is now located twice the distance from the entry level. So, if we were to risk the same amount from the account, the trade size we could enter would be halved.

Concluding thoughts

Calculating the deal size is not based on a random strategy, but rather involves determining the account risks and studying the point of canceling the trade before entering it.

An equally important aspect of this strategy is the implementation component. Once you have determined the trade size and cancellation point, you should not change them after entering the trade.

The best way to learn the principles of risk management is practice, so head over to the Binance platform and test your new knowledge!