Not risking too much money on any given trade is essential for any day trader. Unfortunately, when most people start trading, they do not think about the risk that they are taking – only about the potential rewards.
Every trading strategy must take into consideration the maximum percentage of the total trading capital that should be risked in any one transaction. In fact, a trader’s ability to limit his losses is just as important (or even more important) as his success in managing winning positions.
Think about it. If a trader losses a small amount on every transaction, won’t he stay in the game a lot longer? Taking huge losses is one of the primary reasons why so many traders don’t survive in this business. Why do traders commit financial suicide this way, you may ask? If all big losses start small, shouldn’t it be easy to prevent a small loss from becoming unmanageable? The answer is a resounding “YES.”
Limiting losses in day trading involves a lot of common sense. To begin with, I don’t think any trader should risk more than 2 to 5% of his trading capital on any given trade. Why? If a trader sticks to a 1% to 2% maximum loss guideline, his chances of staying in the game are greatly increased because it will take many consecutive losses to wipe him out and he will have more money-making opportunities available to him.
If a trader will be managing a $10,000 account, he should not lose more than $100 to $200 (1% to 2%) on every position taken. Using the same reasoning, if we are dealing with a trading account that’s $100,000 in size, the maximum allowable loss can be increased to $1,000 or $2,000 per trade. Based on these percentages and on the amount the price can move against the trader (determined from the charts), he can calculate the maximum size his position should have. This becomes much clearer with a numerical example:
Position Sizing Example using Currencies (to learn more about currencies, read this section)
Assume that an investor can trade a lot of 100,000 USD with a 2,000 USD deposit (50 to 1 leverage) and that he has $10,000 in an account. With this account size, he can trade a maximum of 5 lots (5 x 2000 margin deposit = 10,000) at a time – but is this a wise thing to do? Let’s look into this a little further.
Let’s say that based on his methodology, the trader analyzes the chart and determines that in order for him to take a long position with a potential reward of $800 per lot, he must be willing to lose $200 per lot. He realizes that if he takes a 5-lot position and all goes well, he could have a gain of $4000 or 40% (5 lots x $800 per lot = $4,000) on his $10k account. Using a position size of 5 lots would also require that he be willing to lose $1,000 (5 lots x $200 per lot = $1,000). Should he take the trade? Maybe, but not with 5 lots!!!
A loss of $1,000 represents 10% of his trading capital!!! How long will anyone be in business after a few consecutive 10% loses? In this example, his maximum position size should only be one lot. With one lot, he will be risking $200 (2% of his account size) to make $800 (8% return). While it might be tempting to try to make the $4,000 on one trade, I don’t think it is a smart thing to do. Trading is all about your probability of survival. To survive, you
cannot risk more than you can afford. Risking too much is not smart money management.
Position Sizing Example using Stocks (remember that to day trade stocks in the United States, you need at least $25,000 in your account by law – so I will use an account size of $30,000 in the example below)
Assume that an investor has a $30,000 account to actively trade stocks. He wants to trade Intel (INTC) stock, which is at $30 a share.
Based on his strategy, he determines that the stock can appreciate $1.00 a share during the day, but to take advantage of the appreciation, he must risk $0.50. Since he has an intraday margin of 25% (4 to 1 leverage) he can take a $120,000 maximum position in INTC with his $30,000 (4 x 30,000 = 120,000). Should he do it? Let’s do the numbers.
With $120,000, the trader can buy 4,000 shares of INTC (120,000 / 30 = 4,000). If INTC moves up 1 point, the trader gains $4,000. If it drops $0.50 (his stop loss), he loses 2,000. A two thousand dollar loss represents 6.7% of his trading capital – much too big a risk for him to take. Consequently, a 4000-share INTC position is too large for his account size. Based on a 1% ($300) maximum loss, the day trader should not buy more than 600 Intel shares (300 / 0.50 = 600). Based on a 2% ($600) risk, the maximum trade size becomes 1200 shares.
Risk in day trading (or in any other form of speculation) must be controlled. One effective way of managing risk is by not taking on a position larger than an account of a given size can handle. While some authors and “experts” have complicated ways of determining position size, these methods tend to confuse traders and slow them down. The 1 to 2% guideline is simpler to use in my opinion. It is common sense more than anything else. Don’t become another trading statistic – limit your losses all the time with protective stop orders!!! Read more stop orders in the basics section.
Please note that stop orders do not guarantee you’ll get filled at your stop price. If the market gaps against you or there’s not enough liquidity or available size in the market at the time your stop is supposed to get hit, your exit price can be a lot worse than you expected. This is true for any financial market.
Read about the importance of using a specific strategy in trading.