Everything you need to know about position sizing

Obviously, the bigger your stake, the bigger your win (and the bigger you lose!). But there’s a lot more to it than that.

The balance between building wealth and avoiding nasty losses is a nuanced one. Getting your position sizing right can be the difference between a prosperous career in the markets, and a short sharp shock that leaves your account empty.

Here’s how to do it right …

Know your bank size

How much money have you allocated to your trading? It may sound like a simple question, but there’s a bit to think about here …

Are you running multiple strategies from one trading account? Do you know how much is allocated to each of them? Have you put all of the money you’re prepared to trade with into your account or is some of it sitting elsewhere until you need it?

If your trading fund has grown/depleted, do you know exactly what the balance is right now?

If you’re going to be risking a fixed percentage of your fund on each trading position, it’s vital to know what you’re measuring that from.

How to calculate your position sizing

When you open up a trade ticket on your broker’s platform, chances are it auto-fills with a £1 stake. This automation has a lot to answer for, as way too many traders just plod away with £1 stakes, regardless of the size of their bank, where their stops are positioned, or the size of the instrument they’re trading.

The most important thing to consider when deciding on position sizing is your risk. (Margin is also a factor, which I’ll come to in a moment.)

Because we’re trading with stop loss orders, we are limiting the downside on our trades. While slippage can sometimes mean that stops don’t get filled exactly where we’d hoped, if you’re trading major instruments, this is very rarely a serious issue.

So, for the majority of the time, we can safely assume that the risk on our trade is:

stop distance X stake size

For many of us, stop distances vary from trade to trade, which means that our position size on each trade will need to be individually matched to that setup.

So, if you’re risking 2% of a £5,000 trading fund on each trade, that means your risk per trade is: £100.

If your stop distance on that trade is 25 points, then your stake should be £4.

If that trade lost, then your trading bank will now be £4,900, so your risk/trade should be £98.

If the next trade also has a stop distance of 25 points, then your stake size will now be £3.92.

Running through this quick calculation every time you place a trade should be routine. (Unless you’re trading with a piece of software, like Bread & Butter Trader, that does the job for you.)

What about lot sizes?

One of the (many) nice things about spread betting is the use of stake sizes – it makes it nice and simple to work out risk levels on a per-pip basis.

But, if you’re trading an CFD account, you’ll be dealing with lot sizes. So here’s a little explainer …

The lot size you’ll need for a trade will depend on:

• the size of your account,
• the risk you want to take on that trade,
• the stop distance,
• the currency pair you’re trading,
• and the currency your trading account is in.

The calculation is pretty simple, but there are plenty of online tools you can use. (And the Bread & Butter Trader software will automatically do these calculations for you.)

First off, if you’re risking 2% of a £10,000 account, that means a risk of £200.

Now, let’s say that our stop distance is 75 points. That means we’d be looking to risk £2.67 per pip.

If you’re used to spread betting – it’ll all look pretty familiar so far.

To turn this risk-per-pip into a lot size, you’ll need to look at the quote currency of the instrument you’re trading and compare this to the currency of your trading account.

(I’m going to assume your trading account currency is in GBP). So, if you’re trading EURCHF, you’d need to know the value of GBPCHF. If you’re trading NZDCAD, you’d need to know the value of GBPCAD.

Next, we multiply that £2.67 (risk per pip) by this number, and divide the answer by 10 (or 1,000 for JPY pairs)

Let’s say GBPCAD is 1.7590, then for a £2.67 risk per pip, we’d need a lot size of 0.47

( 2.67 x 1.7590 ) / 10 = 0.47

If we were trading USDJPY, we’d need to know GBPJPY (191.20) … and that would calculate a lot size of 0.51

( 2.67 x 191.20 ) / 1000 = 0.51

Matching position size to margin

Because of the almost ubiquitous use of stop loss orders, we tend to think much more about risk in terms of where our stops would take us out, rather than in terms of the size of the instruments we’re trading.

But increased margin requirements in recent years have forced us to think more about the margin on our trades. And it’s perfectly legitimate to calculate position sizing based on margin. However, it’s vital to also keep a close eye on the risk levels of these positions.

Margin requirements in the UK vary from instrument to instrument, but major FX are usually 3.33%, major indices are 5%, gold is 5%, with other commodities at 10%.

So, to calculate the margin requirement on your trade, it’s:

the size of the instrument X the margin percentage X the stake

For example, if you wanted to trade the FTSE at 8000, the margin requirement would be 8000 x 5% for each £1 stake.

=£400 per £1 staked

That’s initial margin (the amount of money required to open a trade. You then add in variation margin – this is the risk level on your trade. If you’re using margin to calculate your stake sizes ALWAYS be aware of what your maximum risk per trade is, and don’t stray above that.

Compounding styles

Compound investing is the only way to build serious wealth from your trading. It needs time to take effect, but when compounding kicks in, the money really starts to roll.

However, even with the steadiest trading methods, trading the financial markets can be a bumpy journey. Success rates can dip below 50%, and in volatile conditions, compounding can feel expensive.

But there are different ways to compound that can fit in with different trading strategies …

If you’re suffering from volatile returns, you can smooth out the effects by compounding less often.

The most aggressive style of compounding will be to adjust your risk/trade after each position is closed. Less aggressive would be to do this weekly, monthly, or even annually.

Other ways to dampen the effects of compounding are to use a throttle – this means that when you come to increase/reduce your risk/trade each month, you’ll only ever adjust the figure by 10% maximum.

So, let’s say you’re risking 1% of your bank per trade, and you’ve had a great month and made 15% gains, growing your bank from £12,000 to £13,800. Your risk/trade last month would have been £120. But rather than increasing to £138 this month, instead it will only go up 10% to £132.

Accelerating compounding

Less-aggressive compounding methods don’t mean that you’ll hit your goals more slowly. As we’ve seen again and again, a smoother profit curve can win out in the long term.

But there’s a simple trick that can put rocket-boosters on the power of compounding …

Adding modest amounts to your fund on a regular basis.

It doesn’t need to be a lot – but those small, regular additions will see the speed at which your wealth grows really pull towards the exponential. The chart below shows the growth of a £1,000 account over 20 years with a 20% pa return, compared to the same strategy, but adding £600 each year to your account …

Managing position size like a pro

The three vital factors to bear in mind all the time when you’re staking are: risk, compound growth, and volatility.

Never risk more than a small percentage of your fund on any trade. Always be working towards reinvesting your winnings to build serious wealth, but temper this ambition with looking for the smoothest profit curve you can achieve, rather than bumping up stakes too fast in the good times.

Don’t make staking decisions on the hoof, based on how much you ‘like the look of’ a trade. Have a plan and be consistent with it.

By balancing these three key elements, you’ll set yourself up for wealth building, while also protecting yourself from the downsides of trading.

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