Reduce Your Risk of Ruin
You’ve done the research. The stock looks like a solid breakout trade — it’s time to log onto your brokerage website and place a limit order… Do you know how big of a position you should be taking?
That’s not just an academic question. The size of your position is arguably one of the most critical elements of your success as a trader. While the trading strategy you use is essential to finding profitable opportunities, sound capital management techniques are just as crucial to longevity as a trader.
As a rule, capital preservation is one of the biggest challenges for new traders. And your position size has everything to do with that.
In fact, one of the most common questions I get is, “How big should my position be in this stock?” I’ll admit, it’s a tough one to answer.
That said, let’s lay down the basics of position sizing…
For starters, you should be trading risk capital only. That means money you’re able to lose without losing sleep. In other words, don’t transfer the mortgage payment or your 401K into your brokerage account to make a trade.
Trading essentially comes down to an odds game — even in a trading system that generates statistically significant positive returns, bad luck can still hurt any individual trade. That’s the number-one reason why you should only use risk capital to trade. Sound money management lets you survive the bad luck and profit in the long run. Psychology is another factor. Knowing that a losing trade means foreclosure or no food on the table adds a psychological burden that can only cloud your trading judgment.
So, how much risk capital should you risk on each trade?
There isn’t a set in stone rule for position sizes. A lot of personal factors, like the size of your account, your risk tolerance, and your experience, all factor into how big of a bet you should make. That said, risk of ruin — that is, the chance that you’ll blow up your account if you hit a “cold streak” — decreases dramatically as your risk approaches 2% or less of your portfolio.
Keep in mind that I’m talking about risk — or money on the line — not total position size. So for a $10,000 account, for example, a trade with a 5% stop loss level would justify a $4,000 position at a maximum. You shouldn’t stand to lose more than 2% of your total account value on any given trade.
Higher risk trades mean that you should be taking smaller positions. On the flip side, incredibly low risk trades allow more experienced traders to use leverage safely.
The best rule of thumb is to stay within your comfort zone. On that $10,000 account, if a $1,000 or $500 position size is the most you’re comfortable with, follow your gut and ramp up to 2% as you gain experience.
For the more mathematically inclined, Futures Magazine features a very good (and more in-depth) foray into the formula for risk of ruin here. Keep in mind that you’ll need an established trading history to actually calculate the risk of ruin stats for your own strategy…
As a trader, it’s tempting to focus on your trading strategy and nothing else. But that’s a major mistake. Make a concerted effort to preserve your capital, and you’ll stand an much better chance of finding trading success for the long haul.
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