No matter how big your portfolio is, youโll need to exercise proper
risk management. Otherwise, you may quickly blow up your account and suffer considerable losses. Weeks or even months of progress can be wiped out by a single poorly managed trade.
A fundamental goal when it comes to trading or investing is to avoid making emotional decisions. As
financial risk is involved, emotions will play a huge part. Youโll need to be able to keep them in check so that they donโt affect your trading and investment decisions. This is why itโs useful to come up with sets of rules that you can follow during your investment and trading activities.
Letโs call these rules your trading system. The purpose of this system is to manage risk, but equally importantly, to help eliminate unnecessary decisions. This way, when the time comes, your trading system wonโt allow you to make hasty and impulsive decisions.
When youโre establishing these systems, youโll need to consider a few things. Whatโs your investment horizon? Whatโs your risk tolerance? How much capital can you risk? We could think of many others, but in this article, weโll focus on one specific aspect โ how to size your positions for individual trades.
To do that, first, weโll need to determine how big your trading account is, and how much of it youโre willing to risk on a single trade.
While this may seem like a simple, even redundant step, itโs a valid consideration. Especially when youโre a beginner, it may help to
allocate certain parts of your portfolio to different strategies. This way, you can more accurately track the progress youโre making with different strategies, and also reduce the chance of risking too much.
For example, letโs say you believe in the future of
Bitcoin and have a long-term position tucked away on a
hardware wallet. Itโs probably best not to count that as a part of your trading capital.
In this way, determining the account size is simply looking at the available capital that you can allocate to a particular trading strategy.
The second step is determining your account risk. This involves deciding what percentage of your available capital youโre willing to risk on a single trade.ย
The 2% rule
In the traditional financial world, thereโs an investing strategy called the 2% rule. According to this rule, a trader shouldnโt risk more than 2% of their account on a single trade. Weโll go over what that means exactly, but first, letโs adjust it to be more suitable for the
volatile cryptocurrency markets.
The 2% rule is a strategy suitable for investment styles that typically involve entering only a few, longer-term positions. Also, itโs typically tailored to less volatile instruments than
cryptocurrencies. If youโre a more active trader, and especially if youโre starting out, it could be lifesaving to be even more conservative than this. In this case, letโs modify this to be the
1% rule instead.
This rule dictates that you shouldnโt 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? Absolutely not! It only means that if your trade idea is wrong, and your
stop-loss is hit, youโll only lose 1% of your account.
So far, weโve determined our account size and account risk. So, how do we determine the position sizing for a single trade?
We look at where our trade idea is invalidated.
This is a crucial consideration and applies to almost any strategy. When it comes to trading and investing, losses will always be a part of the game. As a matter of fact, theyโre a certainty. These are a game of probabilities โ not even the best traders are always right. Actually, some traders might be wrong much more than they are right and still be profitable. How is that possible? It all comes down to proper
risk management, having a trading strategy, and sticking to it.
As such, every trade idea must have an invalidation point. This is where we say:
โour initial idea was wrong, and we should get out of this position to mitigate further lossesโ. On a more practical level, this just means where we place our
stop-loss order.
The way to determine this point is entirely based on individual trading strategy and the specific setup. The invalidation point can be based on
technical parameters, such as a
support or
resistance area. It could also be based on
indicators, a break in market structure, or something else entirely.
There isnโt a one-size-fits-all approach to determining your stop-loss. Youโll have to decide for yourself what strategy suits your style the best and determine the invalidation point based on that.
Looking to get started with cryptocurrency? Buy Bitcoin on Binance!
So, now, we have all the ingredients we need to calculate position size. Letโs say we have a $5000 account. Weโve established that weโre not risking more than 1% on a single trade. This means that we canโt lose more than $50 on a single trade.
Letโs say weโve done our analysis of the market and have determined that our trade idea is invalidated 5% from our initial entry. In effect, when the market goes against us by 5%, we exit the trade and take the $50 loss. In other words, 5% of our position should be 1% of our account.ย
- Account size โ $5000
- Account risk โ 1%
- Invalidation point (distance to stop-loss) โ 5%
The formula to calculate position size is as follows:
position size = account size x account risk / invalidation point
position size = $5000 x 0.01 / 0.05
$1000 = $5000 x 0.01 / 0.05
The position size for this trade will be $1000. By following this strategy and exiting at the invalidation point, you may mitigate a much larger potential loss. To properly exercise this model, youโll also need to take into account the fees youโre going to pay. Also, you should think about potential slippage, especially if youโre trading a lower
liquidity instrument.
To illustrate how this works, letโs increase our invalidation point to 10%, with everything else being the same.ย
position size = $5000 x 0.01 / 0.1
$500 = $5000 x 0.01 / 0.1
Our
stop-loss is now twice the distance from our initial entry. So, if we want to risk the same $ amount of our account, the position size we can take is cut in half.
Calculating position sizing isnโt based on some arbitrary strategy. It involves determining account
risk and looking at where the trade idea is invalidated
before entering a trade.
An equally important aspect of this strategy is execution. Once youโve determined the position size and the invalidation point, you shouldnโt overwrite them once the trade is live.
The best way to learn
risk management principles like this is through practice. Go to
Binance and put your newfound knowledge to the test!
