Some Thoughts on Position Sizing

Just a quick word about position sizing as a tool to manage risk. The first thing I have to determine before entering a trade is just how much I'm willing to lose on that trade. Since I cannot control price action or direction, when I enter the trade, I must assume that there is a probability of loss that I must accept. So for longevity's sake, it is prudent to limit my losses and let my profits run as much as possible.

Some traders use a fixed quantity of pips as their stoploss. Others, identify price levels which have the potential to provide support or resistance, and use a breach of these levels as their stoploss. Either way, there is a quantifiable number of pips one can determine to set a stop order to limit the amount of loss from one's entry point.

The next step would be to determine the amount of monetary loss one is comfortable losing on the proposed trade. I plan to discuss the philosophy of losses in a later post, but for now, lets just assume that a loss, or a string of losses is inevitable. Consider the following:

• Risking 5% on a trade (given a theoretical $100 account) allows for a string of 180 losing trades before zero, assuming no friction for commissions or fees.
• Risking 1% on a trade (given the same theoretical $100 account) allows for a string of 917 losing trades before zero, assuming no friction for commissions or fees.

The assumption that the probability of losing 917 times in a row is far smaller than losing 180 times in a row is justifiable, if not quantifiable. So, what it really comes down to is, how much of a loss does the least amount of damage to the trader's confidence. For the purposes of this post, let's just use 1% of a $1000.00 account, or $10.00.

The chart above illustrates what I would consider a long entry setup for AUDUSD. Macroeconomic factors favor the Aussie, there are some tails (or pin bars, hammers, whatever you prefer) on the most recent closed bars indicating that support is holding. It is a bit troubling that the last series of highs was not higher than the previous, so this trade is not a slam dunk, there is some risk. For me, a break of 0.91 would indicate a setup failure. I've got about 50 pips to play with, so let's determine the lot size to use for this trade, to limit my loss to $10.00. It is rather simple, 10 divided by 50 equals 0.2, which I will use as my lot size, a $2000.00 short Dollar, long Aussie position. If I get 0.9144 as my entry price, I set 0.9094 as my stoploss, 0.9319 appears to be the area of last resistance, it has potential to be resistance again, this will be my target profit. This gives me a 3.5:1 risk/reward ratio.

The formula for position sizing can be summarized as:

Dollar amount to lose divided by pips to setup failure equals lot size.

Knowing this in advance will eliminate any indecision when the time comes to exit a losing trade.