Table of contents

  • introduction

  • How to determine account size

  • How to determine account risk

    • 2% Rule

  • How to determine trading risk

  • How to calculate position size

  • Summarize


introduction

No matter how much you invest, you need to manage your risk accordingly. Failure to do so can lead to a rapid loss of funds in your account. Weeks or months of gains can be wiped out by a single poorly managed trade.

The basic goal of trading or investing is to avoid making emotional decisions. When it comes to financial risk, emotions play a big role in it. You need to manage your emotions when making trading or investment decisions. Therefore, it will be helpful to have a set of principles for investment and trading activities.

We call these principles a trading strategy. The purpose of the strategy is to manage risk while eliminating unnecessary decisions. Whenever a decision is made, the trading system will not allow you to make rash and impulsive decisions.

When you create these strategies, you need to consider many factors. These include investment horizon, risk tolerance, available investment amount, etc. There are many possible solutions, but in this article we will focus on how to determine the position for a single trade.

To do this, we first need to determine how large your trading volume is and how much risk you are willing to take on a single trade.


How to determine account size

Although this may seem like a simple and redundant step, it is still something to consider carefully. Especially if you are a new investor, this will help you identify different strategies for different portfolios. This way you can more accurately track the progress of different strategies while reducing risk.

For example, suppose you believe in the future prospects of Bitcoin and are collecting it in a hardware wallet for long-term holding. It is best not to use this part of funds as part of investment capital. In other words, determining the account size is to review and determine the amount of funds that can be allocated to a specific trading strategy.

Account sizing is all about looking at and determining the amount of money you can allocate to a specific trading strategy.


How to determine account risk

The second step is to determine your account risk. This process indicates how much risk (as a percentage of your capital) you are willing to take on a single trade.


2% Rule

In the traditional financial world, there is an investment strategy called the 2% rule. According to this rule, you should not risk more than 2% of your account on a single trade. We will discuss exactly what this means later, but for now we will adjust this number to account for the volatility of the cryptocurrency market.

The 2% rule investment strategy is suitable for investment styles that only take a small number of long-term positions. It is usually tailored for instruments with low volatility (relative to cryptocurrencies). If you are an active trader, especially a novice, this conservative strategy will be a "lifesaver". In this case, we will adjust it to the 1% rule.

This principle states that you should not risk more than 1% of your account in a single transaction. Does this mean that you should only take out 1% of your funds for trading? Of course not! This value means that if your trading concept is wrong, the stop loss will be triggered and you will only lose 1% of your account funds.


How to determine trading risk

Now that we have determined our account size and account risk, we will determine our position size for each trade.

Now let's look at when a trading idea doesn't work.

This process is critical and applies to almost all strategies. When trading and investing, losing money is an inevitable part of the process. Trading and investing is a game of probability, and even the best traders are not guaranteed to always win. In fact, some traders make more mistakes than they are right, but still win. How does this happen? In general, it comes down to proper risk management, developing a trading strategy, and sticking to it.

Therefore, every trading concept should have a failure point. In other words, when the market goes against our initial concept, we should exit the current situation to reduce losses. In more practical terms, this means that we set a stop loss order at a certain position.

The determination of the failure point depends entirely on one’s trading strategy and setup habits. The failure point can be based on technical parameters such as support or resistance levels. Or it can be based on other factors such as indicators that undermine the market structure.

There is no one "one size fits all" point in the market to determine your stop loss. You must determine the investment strategy that best suits your style and determine the invalidation point based on that strategy.


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How to calculate position size

Now we have all the elements to calculate position size. Let's assume we have $5,000 in our account. We have set a limit of 1% risk per trade. This means that we cannot lose more than $50 on a single trade.

Let's assume we have done our market analysis and have determined that the invalidation point in our trading concept is 5% of our entry. We will exit the trade when the market turns unfavorable and the loss reaches 5%, which is $50. In other words, 1% of our account is 5% of our position.

  • Account Size – $5000

  • Account risk – 1%

  • Invalidation point (Stop loss range) – 5%

The formula for calculating position size is as follows:

Position size = Account size * Account risk / Expiration point
Position size = 5000 x 0.01 / 0.05 (USD)
$1000 = $5000 x 0.01 / 0.05

The position size for this trade should be $1,000. Following this strategy and exiting the trade when it reaches the invalidation point will reduce losses. To use this model correctly, you also need to take into account the transaction fees that should be paid. Also, you should consider the risk of depreciation when trading low-liquidity assets.

To explain the principle, we increase the invalid points to 10% while keeping the other factors unchanged.

Position size = $5000 x 0.01 / 0.1
$500 = $5000 x 0.01 / 0.1

Our stop loss is now twice as wide as it was at the beginning, so if you are willing to lose the same amount of money in your account, your position size will need to be half as large as before.


Summarize

Position sizing is not something you do randomly. It includes many factors such as account risk, invalidation points of your trading ideas, etc., which all need to be considered before trading.

Another important aspect of this strategy is execution. Once you have determined your position size and expiration point, you cannot overwrite it while the trade is in effect.

The best way to learn the principles of risk management is to practice. Head over to Binance to put your new understanding to the test.