Why Position Sizing is Important
Position Sizing refers to determining the most suitable investment for a single trade. Deciding to invest 10 euros rather than 100 is already Position Sizing. It's an important topic, as exposure is correlated with risk but also with opportunities. Investing a lot means risking a lot, and it also opens the door to larger gains. Position Sizing, therefore, is an activity that rests on a delicate balance between risk and opportunity, loss and gain, impoverishment and enrichment. It's evident that it cannot be left to chance or intuition. For guidance on setting that starting figure in the first place, see how much money to invest.
As all traders have experienced firsthand, making choices based on intuition is a terrible idea. Lucidity and the ability to reason with a cool head are two precious assets, but also unreliable ones, especially in moments of stress. And the practice of trading, including Forex, is a stressful moment. Perhaps it's one of the most challenging moments of acute stress ever. Also because money is always at stake. It's obvious, therefore, that one runs the risk of being overwhelmed by emotions, and emotions almost by definition reduce the space for lucidity, for speculative reasoning.
Is there a solution to all this? Obviously yes. This is not a magic wand, but rather a resource that is certainly useful, and that provides a compass during phases that, otherwise, would be governed by chaos or, even worse, by emotions. This solution is represented by rules. Those who establish rules for themselves set a track to follow. In this way, it's more difficult to "get lost," it's more difficult to make mistakes. This obviously also applies to Position Sizing. If exposure is determined according to a system of rules, everything is simpler. Above all, there is a lower risk of making mistakes.
A Simple Method
To say it upfront: there is no infallible method, not even when it comes to Position Sizing. Part of the trading activity is tied to the concept of chance, that is, to randomness. There is always the risk that a trade will go wrong, even when it is the result of a prudent approach and subject to rational rules. In the same way, an exposure can turn out to be reckless or, on the contrary, too "timid" even when the best Position Sizing methods are applied. It can easily happen that in hindsight a position turns out to have been too small, and you are left looking at a wasted opportunity. It happens just as frequently that an investment may turn out to be too bold, obviously after a loss.
In any case, working with imperfect rules is always better than working without rules. Now, there are many rules, or rather methods for Position Sizing. This paragraph presents the simplest one, while the next one presents the method that, over the last few years, has gained the most success.
The simplest method is so simple that it doesn't have a name. It can be said that it responds to the natural instinct of any investor, beginner or expert. It is the result of a kind of optical illusion, of a cognitive bias that forces the mind to reason in proportions, and therefore always in relation to one thing with another.
It could be defined as the percentage method. Very simply, it is a matter of always risking the same percentage of capital on each trade. In this way, rash decisions are avoided, which among other things can always happen when trading: as already mentioned, the trader risks being overwhelmed by emotions, and among these there is the desire for revenge, which pushes to invest more and more to recover a loss. How much the chosen percentage matters becomes clear when the risk of ruin is calculated for different position sizes.
In any case, the percentage universally (and arbitrarily) recognized as balanced is 2%, although some tend to go down to around 1% and others aim for 3%. The 2% is the amount you are prepared to lose if the stop is hit, not the size of the position: with a 10,000 account it means a maximum loss of 200 per trade, and the position is then sized from the distance to the stop and the pip value (a wider stop means a smaller position, a tighter one a larger position). With leverage, putting 2% of the account into a trade and risking 2% of the account are two very different things. It is an obviously conservative method: at 2% of the starting capital it would take fifty consecutive losses to wipe the account out, and at 2% of the current capital the account shrinks with each loss but never actually reaches zero. For how that stop distance interacts with volatility specifically, see position sizing in volatile markets.
The Kelly Method
The Kelly method is a different story. Or rather, the formula is. Kelly was not a trader but a physicist at Bell Labs. In 1956 he published, in the Bell System Technical Journal, a formula devised for the problem of noise on telephone lines, and it was soon realized that the same formula was useful above all for managing risk, that is, exposure to it. A formula that is only apparently complicated, but which in truth can be used by any trader. The formula is as follows.
K = W − (1 − W) / R
Where K stands for the fraction of capital to put at risk on each trade. This is a percentage normalized to 1, so the value 0.1 actually corresponds to 10%, the value 0.01 to 1% and so on.
W stands for probability of winning. This value can be derived simply by relating the number of wins obtained by trading on that asset to the number of trades executed (always on the same asset). All, of course, normalized to 1.
R, on the other hand, is the ratio between the average of the wins and the average of the losses, always for the same asset subject to Position Sizing.
Here is an example. Assume a 40% probability of winning and a 1.6 average win to average loss ratio. The formula will be as follows:
0.4 − (1 − 0.4) / 1.60
An expression that when solved produces:
0.4 − (0.6 / 1.6) = 0.025
In this case, the formula suggests risking 2.5% of the capital on the trade.
Tips for Good Position Sizing
What has been described so far is only a part of the gigantic topic of Position Sizing, which in turn is only one of the many topics of money management and risk management. Mastering these simple methods, however, already offers a certain advantage. Provided, however, that you take the matter seriously, and adopt an intelligent approach. For a more direct take on the amount question, see how much to invest in trading. To do this, follow these tips.
Establish rules for Position Sizing long before trading. Choosing under stress is dangerous, and this also applies to Position Sizing rules. The advice, therefore, is to establish the rules in a state of serenity, away from pressure.
Try several methods, but in complete safety. It is legitimate to try several Position Sizing methods, but to use them, utilize demo accounts or backtesting, that is, test the methods either in a real simulation (demo account) or on past market moments (backtesting).
Never derogate from the rules you have set for yourself. Once you have made a choice, unless there is strong evidence to show you that it is wrong, continue along that path. Changing often is not a good idea, if it is not supported by compelling data.
