At the sight of a column of sunlight through the clouds this week, my mind has turned to the summer holidays, and then to whether or not I need to lose some weight!
The thing with diets is that no matter how much cabbage soup or how many grapefruits they prescribe, it always comes down to one crucial factor – I eat too much.
My portion sizes are too big and I’m just plain greedy. And this is the key issue –how successfully I can follow the latest bizarre rules of some diet plan.
I see many traders battling with a similar problem. No, not their weight (although sitting at a trading screen all day does little for your waistline!) – I’m talking about greed in general, and position sizes in particular.
So, why do traders who can religiously follow the rules of a strategy then go and spoil it by piling too much onto their plates?
There are many reasons why traders get position sizing wrong: it could be by mistake; or because they’ve failed to fully assess the probability that losing runs will come along; or that they have false expectations of the kind of returns they can achieve from trading…
All these are understandable, but getting your position size wrong is the most costly error you can make in trading. It’s the one that will wipe you out. So it’s vital that you have a foolproof system in place so that your trade sizes are always safe and sensible.
The 2% rule – and more
As a general rule of thumb, short-term traders follow a 2% rule. This states that you should never risk more than 2% of your pot on any one trade.
By ‘pot’, I’m not talking about your life’s savings that you’re relying on to live off in your old age – I’m talking about 2% of the fund you have allocated for trading (the money you can afford to lose).
By following this rule, if you hit a losing run, those losses shouldn’t hurt too much. All trading strategies will have losses along the way – it’s part of the process. And those losses have a nasty habit of coming together, in losing runs.
Many traders underestimate the probability of getting a losing run – they are a lot more common that you might think. They don’t come along ‘if you have bad luck’ – they just plain come along.
And the more you trade, the thicker and faster the losing runs will come!
Which brings me onto another subject: heat.
The ‘heat’ of your trading portfolio is calculated not just on how much you risk per trade, but also on how many trades you have open at one time.
So, if you risk 3% per trade and only have one trade open at any one time, then your portfolio heat is 3%.
However, if you risk 1% on a trade and have 8 trades open at a time, then your portfolio heat is 8%.
You may think: what’s the chances of all 8 trades losing?
Well, again, unless they have been carefully hedged against each other, this is probably more common that you’d think. Sudden market swings in one direction aren’t that unusual.
Unlike the 2% rule, there isn’t a simple answer to how ‘hot’ your portfolio should be – it’ll depend on whether your trades are hedged (even partially), the size of your portfolio, and the volatility of the markets you’re in.
The effect this has on your results…
Sticking to a 2% (or even better, a 1%) rule will seriously dampen the volatility of your trading fund – you know: those ups and downs that can leave your head spinning and your stomach churning.
I know, you may enjoy the volatile ups – but the downs that naturally come with those fluctuations mean that you’re seriously risking your entire trading future.
No matter how good the up-swings feel, if you get knocked out by a losing run, your trading career will be a short one.
This way, any loss you take should never be more than 1 or 2% of your fund. If you follow this route, you’ll find that you care less about whether you’re right or wrong on any given trade, and you’ll naturally start to see the bigger picture – the goal of long-term profitability instead of sweating the small stuff.
Okay, so let’s assume that you’re sold on the 2% rule…
How do you translate that risk level into the correct position size?
Your position size for spreadbetting, is the size of your stake.
And the risk on your trade is the size of your stake multiplied by the distance to your stop loss.
So, let’s say that you have a trading fund of £5,000, and you’re prepared to risk 2% of that on your trade. You’re going to buy GBPUSD with a stop loss 40 pips below your entry level.
Your total risk on the trade should be £100 (that’s 2% of £5,000). That’s the maximum you can expect to lose if the price runs to your stop loss.
Therefore, your stake should be £2.50 (£100 divided by 40 pips).
This kind of sensible position sizing is essential if you want to succeed in trading and achieve long-term profitability. If you push your position sizes too big, you may get lucky with a few nice winners, but no matter how much you cross your fingers and stroke your lucky rabbit’s foot, you’re not going to avoid losing runs! And they can quickly put a stop to your fun.
However, with careful position sizing, you’ll always be prepared for losing runs when they strike, and you will have a solid foundation to build long-term wealth.