Calculating trade size.
Trade size should be considered when calculating risk. One of my “Newbie” blunders was to not understand this. Understanding risks will help in understanding your exposure and determine the amount of capital you would want to put into a single stock. Trade size can vary from trade to trade because of type stock, your entries, stops, and size account varies constantly.
Calculating proper trade size is a relatively simple process that can help you yield greater profits. One technique is using this formula: Risk amount (how much you put into the trade) – commissions, divided by the difference in entry and stop equals trade size. Example: You are willing to drop $1000 on a $5 stock and except an 8% stop loss (risk amount). Your commissions are $10. So you end up buying 150 shares ($80 risk amount (8% of $1K) -$20 commissions (buy/sell) divided by .40, 8% stop from $5). I use a similar system using a percentage of my portfolio.
You need to learn the risk per trade. Most novice traders tend to focus on the outcome and therefore do not think of the risk. Professional traders focus on the risk and take the trade based on their proven trading system. The psychology behind trading size begins when you believe that each trades outcome is unknown at the time you enter the trade. This should trigger the question: How much am I willing to lose on this trade?
Once you begin to think with that question in the forefront, then honestly answer it, you can apply your own money management rules. You may want to adjust the trade size or tighten/loosen your stops-loss before entering the trade. In most situations, it is best to adjust trade size and set your stop-loss based on market dynamics. Whatever you use, try to be consistant.
During tougher periods of market drawdown, risk control becomes very important. Experienced traders test their systems continuously, so they have an idea how many consecutive losses they can take before it becomes unbearable. Taking this into account will further help you determine the appropriate risk percentage for each trade.
You need to understand that not every trade will be a winner. The best systems out there are only right about 60% of the time. So, at best, for every ten trades, four will be losers. This goes back to that question: “How much can I afford to lose on this trade?” Even back tested systems that show an 80% success rate fall back to the 60% area when they start putting money into the system. This is due to the human factor in most cases. Humans tend to doubt the system and to not execute in accordance to the system (fear/greed syndrome).
So, if you are losing 40% of the time, you need to control risk. Implementing stops and controlling trade size helps you control risk. You cannot know which trades will be successful, and as a result, you must apply risk control to every trade. If you effectively control risk, and have more winning trades than losers, you can sustain several multiple losses without devastating your account and/or your emotions.
By not controlling risk and using improper trade size, you can be broke in no time. It usually happens like this: They begin trading, get five losses in a row, don’t use the proper trading size, and don’t cut their losses soon enough. After five losses in a row, those traders don’t have enough capital to continue. And this scenario can happen very quickly. So learn to control risk, and trade successfully.
