Position Sizing: How Much Capital Should Be Put at Risk Per Trade

Position sizing is the process of working out how many units of any asset to buy or sell while trading. It is a key component of risk management that helps traders minimise losses and maximise overall returns. 

Why Position Sizing Matters

Position sizing in trading helps manage risks. Here are some of the reasons why it matters: 

• Position sizing depends on available capital, risk tolerance, and the stop-loss level and entry price. It is vital for calculating potential investment returns, success probability, and downside risk. 
• Position sizing matters because traders can use it to avoid overexposure to any market risk or single asset.
• Position sizing is vital for long-term financial success, particularly for active traders, i.e., currency traders and day traders. 
• Of course, you should know how to use a position calculator for stocks to make informed decisions. 
• Position sizing helps limit the risks that you take on any particular trade while optimising the reward potential. Bigger position sizes are taken on more favourable reward/risk scenarios. 
• Using the rule-based sizing approach helps ensure higher discipline by eliminating emotion-based decision-making. Here, traders are less likely to chase a trade or overtrade. Suitable sizing across multiple positions helps diversify risk and safeguard against market fluctuations. 

Common Position Sizing Models

To understand position sizing in trading, let us look at the common models used. These include the following: 

• Fixed Rupee Amount
  This model allocates a predetermined or specific rupee amount for every investment. This is done irrespective of the volatility or price of the asset, thereby simplifying capital allocation and risk management. However, position size is not adjusted based on the account balance, leading to under/over-allocation as your account grows or shrinks. 
• Percentage of Account Balance
  This position sizing model allocates a fixed percentage of the trading account for each trade. Thereby, the position size is adjusted with changes in your account balance. It helps limit potential losses for any single trade and is a scalable model as well. 
• Risk Per Trade (Stop-Loss Based)
  Stop-loss levels are predetermined prices, and the trade will automatically close to prevent any further losses (if the market goes against you). Thus, working out the position size in this case will require you to first determine the risk per trade and then divide it by the risk per share. 

Calculating Proper Position Size

Position size formula: Position size can be calculated by using a mathematical model like the Kelly Criterion (which helps determine the optimal position size). You may use a calculator to do it automatically. 

The basic aspect is determining the risk per trade (the percentage of the account you’re comfortable risking) and the risk per unit (stop-loss distance in price points or pips). You can then divide the risk per trade by the risk per unit to find the suitable position size. 

Of course, calculations vary as per the asset that you’re trading, including stocks, futures position sizing, options, forex, etc. You should always use stop-loss orders to limit potential losses while diversifying trades to spread out risk. 

Tools & Spreadsheets for Position Sizing

There are several tools and spreadsheets that you can use to determine position sizing, including free online calculators and customisable spreadsheets for risk management. You will also find multiple built-in sizing tools across trading platforms, along with trade management tools that can automatically calculate the position size. Other tools include structured money-management plans and account-size limits set by brokers.

While trading, you can use these tools to input specific risk parameters and other account details to understand the optimal position size for every trade. This helps eliminate emotional biases from sizing decisions while enabling responsible risk management practices. 

Mistakes to Avoid 

Some of the mistakes to avoid in position sizing include: 

Over-Leveraging

This is when you use excessive borrowed money or leverage relative to the account balance. It may amplify not just your potential gains/profits but also your losses.

Small price movements may lead to major losses when you are over-leveraged, and your position size is too large relative to the account balance. 

If the market goes against your position, the account's equity may fall below the required margin level, leading to what is known as a margin call (the broker asks you to deposit more funds or liquidate positions to cover the gap).

Failing to meet this requirement may lead to the broker automatically closing positions, resulting in capital losses.

Make sure you’re adjusting your position size smartly as per your risk tolerance and use a predetermined stop-loss level for better risk management, ensuring that you do not take excessively large positions for your account size. Keep sufficient capital on hand for covering any potential losses. 

Ignoring Stop-Losses

Neglecting stop-losses is risky in position sizing. This can lead to major losses since it may undermine the basic philosophy of risk management: restricting losses. By not setting or maintaining stop-loss levels, traders may end up exposing themselves to potentially bigger losses in case the position goes against them.

You should calculate position sizing based on the predetermined stop-loss level, thereby ensuring that the potential per-trade loss stays within a manageable level of risk. Otherwise, it may lead to huge losses in case the market goes against your position. You may also hold onto losing positions due to emotional biases.

Do not forget to periodically review stop-loss levels and tweak them as per changing market conditions.

Conclusion

As you can see, position sizing is a vital risk management strategy, with the core objective being to limit potential losses and maximise the chances of making a profit. Of course, you should determine suitable sizing models and avoid some common mistakes mentioned above.

Experts often feel that you should not risk more than 2% of trading capital on any one trade, while some recommend keeping it at 1%.

Another rule is 3-5-7, which recommends limiting risk to 3% of trading capital for one trade, keeping exposure to 5% across all trades, and ensuring that winning trades yield at least 7% higher profit than losing trades. Work out the right model and proceed accordingly.