Everyone wants to enter big trades and hit home runs.
Traders usually study technical and fundamental indicators and enter positions on stocks that have the potential to gap up.
But a common question that can dramatically affect the success of traders is…
“What’s a good position size — how much money should I risk on a trade?”
Well…why is Position Sizing Important, anyway?
As a trader, you should always try to be in control and avoid making emotional, desperate decisions.
Swing trading isn’t gambling.
Entering trades with random position sizes or based on your intuition will almost always end badly.
And having a world-class strategy doesn’t make up for a wrong trade size — where you’re risking too little or too much (which is a recipe for disaster).
To keep it simple…
Position sizing is determining the amount to allocate to a given trade — while considering risk levels and how it affects my overall account.
Before I open a position, I’m always aware of how much risk I’m taking and how it will affect my account.
Here are two common methods I use to determine position size when trading penny stocks:
The Percent Risk Method
This is a well-known (especially by day traders) method of determining how much to risk on a trade.
The gist of this method is that traders risk a fixed percentage of their account on each trade.
This percentage could be anywhere from 0.5% to 2% or even 5%.
A logical rule most people follow is reducing the risk-per-trade percentage as their account grows. Because 1% of a $30,000 account is $300, while one percent of a $500,000 account is $5,000.
As you can see, there’s a major difference.
When starting out, it makes sense for beginner traders to keep this number low, as they learn the markets and figure things out. Over time, with more experience, they can then up this number to maybe 2%.
In order to determine my position size, a handy formula I use is;
Position Size = Account Risk / Trade Risk
Now, the two things I need to figure out my position size is my;
- Account Risk
- Trade Risk
These two variables are pretty easy to calculate and to do that, I usually keep three key values in mind;
- Capital in my trading account
- Entry price
- Stop-loss price — where I’ll get out if the trade goes south.
How to find my account risk: As I mentioned earlier, this is the percentage of my account I’m willing to lose on one trade. In my opinion, a good number to stick to is 1% (and it could be lower if I’m just starting out).
So if you have a small $10,000 account, and your account risk is 1%, this means you could potentially lose up to $100 per trade.
How to find my trade risk: Remember, I mentioned entry price and stop-loss price as things I keep in mind?
To find my trade risk, I simply subtract my stop-loss price from my entry price.
Then I put it all together using this formula:
Position Size = Account Risk / Trade Risk
For example, if my account risk is $100 and my trade risk is $5, that means I can buy…
100 / 5 = 20 shares.
Important note: Penny stocks are volatile and the market, in general, is unpredictable. It’s wise to avoid putting too much of the capital into one trade.
That’s why some experienced traders limit positions to maybe a third or a quarter of the trading capital.
Fixed Dollar Method
This is another way of determining the number of shares to buy. Most traders use this method to identify a dollar amount they’re comfortable with losing on a given trade.
Simply put, the fixed dollar method allocates a certain dollar amount to each stock trade.
Here’s how this works:
To find out how many shares to buy, I simply divide the amount I’m willing to allocate to each position by the entry price.
So let’s assume I have a $10,000 account and would like to split that capital to 4 different trades…
This comes out to $2,500 per trade.
If I’m buying a stock that is currently trading at $4, I simply divide $2,500 by $4 and that lets me purchase 625 shares.
Most traders like to allocate between $1,000 to $2,000 per position.
Please note: It’s important to keep commission costs in mind as they can easily affect small positions and eat into profits. Most brokers don’t charge commissions anyways.
Position sizing, when done correctly, can increase your chances of success as a trader. It helps prevent excessive (and unnecessary) losses.
If you have a sound risk management plan and follow it, chances are you will not lose a significant portion of your capital on a single trade.
There are two common methods of determining position size — Percent Risk and Fixed Dollar.
The goal is to establish an appropriate percentage you’ll risk on each trade…the sweet spot. Remember, if you risk too little your account stays stagnant…and if you risk too much, your account can get ruined in a blink.