Over the past couple months we have received numerous questions on position sizing, trade allocation and money management. This article goes to address these, but first:
Are you one of those traders that have seen your trading account go from 5k to 2k in less then 3 months?
Are you one of those traders that are in 3,5 or more trades in the same sector at the same time?
Do you wonder how much capital you should allocate to any one trade?
Do you know the difference between a gambler and trader?
Then this article is for you!
“Gamblers obsess with big potential upside windfall profits. Intelligent speculators obsess with managing downside risk.” Peter Brandt
Some of the questions we receive are:
How to calculate the position size?
Where and why do we size less or more?
How much of one’s capital is allocated for one trade?
Why don’t we take more trades in crypto especially smaller alt coins?
The purpose of this article is to go over Marc and my philosophy on position size for trading and answering the questions above, but first there are a few things to understand about markets and it starts with risk.
In order to determine your position size for a trade, you first need to define your risk. This is the key component in determining your trade size. Before you enter a trade the first thing one should determine is “how much am I willing to lose”? This is “managing downside risk”. Not only for a trade but in life. IF you need the $5000 in the next year for a house, car or to pay your kids college, you are gambling, not investing. Never risk more in any market than you are willing and able to lose entirely.
The #1 goal of a trader is not to make money, but to protect capital. PERIOD! Hopefully after reading this you understand our philosophy in trading and how, why and where, we position size.
“I am always thinking about losing money as opposed to making money.” Paul Tudor Jones
As our members know we separate out our investing and trading accounts. We do NOT mix them. Two different strategies with a specific amount of capital allocated to each. This does not mean you have to be both a trader and an investor, but if you are, separate your capital. In simple words, do not use your IRA or long term investments for trading. Selling your Apple stock to trade NBEV is not risk management it is gambling.
If you are investing for the long term, and want to trade, do not allocate capital for your retirement for short term trading. Discretionary money only should be used for trading.
If you are trading stocks, there are various sectors that do not correlate, which is why, in general, there is always a trade in the stock market. However many sectors do correlate and stocks within a general sector are heavily correlated in general. Yes there are out runners but this is the exception not the general rule. Let’s take a look at a few oil majors.
The chart above is of three major oil companies that include upstream and downstream. Notice the correlation. If you have 3 separate trades with all three of these companies, you really have one BIG trade on the oil majors. This is too much trade exposure to one sector. If you lose on one, chances are you lose on all three. This is no different than trading semi-conductors, tech in general, retail, REIT’s, transportation etc. Ever notice the first company to report in a sector, generally drives the sector as a whole?
The same goes with cryptos, so ask yourself would you have 3-4 trades on oil majors if the bottom line you are trading oil?
Again the correlation is very evident. Now there may be some outliers but if you have 10 trades on and only 1 is an outlier, than you are still running the risk of losing on 9 trades. What is the #1 goal of a trader? Capital preservation.
This is why we only swing trade one crypto instrument at any one time. If Bitcoin goes up, 90% of the market will go up as well. If Bitcoin goes down 90% of the market goes down with it. So it does not matter if you are trading 5 or 10, you are really trading the sector, or in this case Bitcoin.
One reason we are focused on swing trading Bitcoin is obviously the performance. It held up better than 95%+ of the coins out there. If I am trading oil stocks, my focus is on the best chart, not a shotgun approach across the board. One trade in the best company or coin in a sector is generally the best trade. Why? Because it limits your downside, better companies do not fall apart like crappy companies, and the same with coins.
Your risk is the combined total of all your trades in a particular sector. This is the precise reason we only trade one cryptos instrument at a time. So how much capital should be risked in a single sector or trade?
Note on Forex:
When trading forex you are really trading long or short the US Dollar. Around 88% of Forex trading are USD pairs. As Marc mentioned in his Forex Trading Guide you are really trading against the dollar. If you are interested or currently trade Forex, you will not find a better guide or in depth insight anywhere online.
Typically we do not want to risk losing more than 1-2% of our trading capital on any one trade 3% when there is a defined broader trend. The goal of every trade is not only to make money, but to be in a position to trade the next day. There are times you go through trading slumps, 4-5-6-8 losses in a row. Managing risks is what keeps a slump from being a capital killer.
Often we see traders applying this incorrectly. There is an important correlation among sector participants, and it is just as important to identify sector correlation to avoid over exposing your risk capital. So how do we calculate our position sizes? Thankfully there is a formula but first risk appetite.
Often we will post a trade as “aggressive” or “highly aggressive”. There is a reason for this. With aggressive trades we do not want to risk more than 1% of our trading capital, highly aggressive trades even less 0.5%. In Forex or alt coins 1% is the standard risk. For stocks or something like Bitcoin we often will take a 2% risk.
I know everyone is trying to hit a home run. Yet there are few baseball players that are consistent in swinging for the fences. It is the base hit guys that win ball games, not home run sluggers. If you have not seen “Money Ball” I recommend you do. Trading is no different. So what is the simple formula?
Calculating Position Size Swing Trades:
Let’s take a minimum $5000 trading account (TA). Using the 1-2% model as a base we can risk $50-$100 per trade. This does not imply you’re position size is $50-$100, this is the amount you are risking on a single trade. So let’s use an example of a typical trade.
The formula used for determining position size is (%risk)xTA/(Buy-Stop)
BUY STOP: 6500
STOP LOSS: 6300
First we determine risk. For Bitcoin I personally use 2% so let’s calculate how capital to allocate.
(0.02)x5000/(6500-6300) = 0.5 BTC
So we would look to buy 0.5 (1/2) a Bitcoin for this trade. With a $5000 trading account that eats up a good portion. There is no reason to add other coin trades here. It leaves a little capital just in case we add a second trade.
BUY STOP: 55
STOP LOSS: 48
Again using 2% as our criterion we come up with.
(0.02)x5000/(55-48) = 14 coins
This formula is the same for stocks. For Forex and Futures the calculation is a little different. Since we trade Forex on our site, this is the formula we use for Forex Trades.
Forex position sizing uses pips and “pip value”. For the EUR GPB AUD CHF and CAD each pip is worth $10 per standard lot, $1 for mini lot, and 10 cents for micro lot. We trade in mini lots so the pip value we use is $1. As a general rule $2000 minimum to trade mini lots, $500 to trade micro lots. Again for a more in depth summary for trading Forex, read Marc’s Forex Trading Guide.
Formula is (%risk)xTA/(pips x pip value)
SELL STOP: 1.1500
STOP LOSS: 1.1550
R:R = 1.25
Using 2% as our criterion we come up with
(0.02)x2000/(50×1) = 0.8 mini lots.
Again depending on the nature of the trade such as aggressive, or highly aggressive, or if the pip spread is higher than 50 we will reduce our %risk accordingly. What this implies is if you normally use 2% we are reducing this to 1% or essentially half our normal trade size. For highly aggressive trades we will even go less than 1%. Often we will also divide our trade allocation into fractional entries. In this case we may step in initially with 0.4 mini lots, and look for a pullback or continuation to add. In the end though, our maximum risk is 0.8 mini lots period.
We added a Trade Position Calculator for cryptos, stocks and forex which you can view here.
Position Trade Sizing:
This is quite different than swing trade sizing. With position trades we look to not risk more than 2-5% of our overall portfolio for any one trade. The reason is we do not generally use stop losses, as these are longer term trades. This article does not address position sizing but I wanted to mention it here.
This hopefully answers many of the questions we received, so let’s summarize them up.
Answer to Questions:
How do we calculate position size?
- Based on risk capital and the formulas provided above.
Where do we size less or more?
- Based on the aggressive nature of a trade.
How much of one’s capital is allocated for trading?
- Risk no more than you are willing to lose and allows you to sleep at night.
Why don’t we take more trades in crypto especially smaller alt coins?
- Because they are correlated with Bitcoin, and the downside risk (including slippage) is greater in alt-coins than Bitcoin.
Making money in the market is all about Risk Management, much more than being right all the time. If you average R:R is 1.5 and are hitting 50% of your trades, over time, you are making money IF and only IF you are using proper trade sizing. It is all about consistency and risk management. Even great traders go on losing streaks, if you haven’t you are new to trading. However consistency and money management is what keep a losing streak from becoming a knock out, once you hit a winning streak again.
IF your focus is on how much am I going to make, than you are likely a gambler. IF you find the need to be in 5-8 crypto trades at any one time, especially in a range bound market, you are more fit for a gambling site not a trading one. Are you risking more than you can afford to lose, or lose sleep at night? Well then you need 1-800-gambler and help.
Likewise IF your focus is “how much can I potentially lose”, “what is my maximum risk in a sector”, “have allocated discretionary cash responsibly” than you are thinking like a professional trader / speculator. It is that simple!