1. Capital Protection
The first rule in trading is easy: Don't lose all your money. Regardless of how great your strategy is, losing sequences are unavoidable. Position sizing ensures that even a sequence of losing trades won't wipe out your account.
For instance, risking 10% of your capital per trade can have a 5-trade losing streak reduce your account by half. But risking only 1–2% per trade leaves you with some margin to survive and get back.
2. Risk Control
Position sizing is the connecting link between your risk tolerance and your trading strategy. It keeps you from being over-exposed on one single trade.
Traders usually employ a guideline such as the 1% rule, under which they risk not more than 1% of their overall capital in one trade. Assuming that you have an account of Rs 10,000, you would risk Rs 100 per trade. Included in that is the distance to your stop-loss, which is the extent to which you're going to allow a trade to go against you before closing.
3. Decreases Emotional Trading
Overexposure can cause anxiety, leading to emotional decision-making. When you’ve risked too much on a single trade, small fluctuations can feel like huge swings, causing fear or greed to take over.
Proper position sizing keeps your emotions in check. You’re more likely to stick to your plan and follow your system objectively when the risk is within your comfort zone.
4. Consistency and Longevity
Position sizing contributes to a consistent trading method. It enables you to ride out drawdowns and benefit from winning periods without wildly alternating account balances. Consistency is the key that keeps traders in the markets for years, not days or weeks.
5. Without Blowing Up, Maxing Gains
Most traders believe that to become rich overnight, one should go "all in" on a good setup. But the quickest way to be broke is to overleverage. Strategic position sizing enables you to scale up responsibly when your strategy is performing and cut damage when it doesn't.
A Simple Position Sizing Formula
Here's an easy formula to compute position size:
Position Size = (Account Risk × Account Balance) / Trade Risk
Where:
- Account Risk is how much of your account you’re willing to risk on one trade (e.g., 1%).
- Trade Risk is the dollar amount between your entry price and stop-loss price per unit (e.g., Rs 2 per share).
Example:
- Account balance: RS 10,000
- Risk per trade: 1% (RS 100)
- Entry price: RS 50
- Stop-loss price: Rs 48
- Trade risk per share: Rs 2
Position Size = Rs 100 / Rs 2 = 50 shares
Therefore, you would purchase 50 shares in order to maintain your risk tolerance.
Common Position Sizing Mistakes
- Ignoring stop-losses: Without a stop-loss, your position sizing is irrelevant because your potential loss is unspecified.
- Taking trades on gut feeling: Always compute your position size based on a predetermined formula, not emotion.
- Risking the same dollar but disregarding volatility: Equities with high volatility should tend to have lower position sizes.
- Not scaling according to changing account size: When your account gets bigger or smaller, your risk per trade should change with it.
Conclusion
Position sizing is not a sexy aspect of trading, but it's perhaps the most crucial. It's your defense against huge losses and your methodology for consistent growth. Without it, even the best trading system will break down. With it, even a mediocre system can bring long-term profits.
Whether you’re a beginner or an experienced trader, mastering position sizing is non-negotiable. Start small, respect risk, and remember: the goal is to stay in the game long enough to win.
