What's the best way to size your trades?

1 Why trade size matters

The size of your trades affects your potential profits and losses, as well as your exposure to market fluctuations and volatility. If you trade too small, you may miss out on significant opportunities and limit your growth potential. If you trade too large, you may risk losing more than you can afford and damage your trading psychology. Therefore, finding the right balance between risk and reward is essential for long-term success and consistency.

2 Fixed percentage method

One of the most common and simple ways to size your trades is to use a fixed percentage of your account balance or equity. For example, you may decide to risk 1% or 2% of your account on each trade, regardless of the market conditions or the trade setup. This method ensures that you keep your risk proportional to your capital and that you do not overtrade or undertrade. However, this method also has some drawbacks, such as reducing your trade size during a drawdown and increasing it during a winning streak, which may affect your performance and emotions.

3 Fixed dollar method

Another way to size your trades is to use a fixed dollar amount per trade, regardless of your account size or the trade parameters. For example, you may decide to risk $100 or $200 on each trade, no matter what. This method allows you to maintain a consistent trade size and avoid the effects of compounding or depleting your capital. However, this method also has some disadvantages, such as not adjusting your risk to your account growth or decline, and not taking into account the volatility or the stop loss of each trade.

4 Kelly criterion method

A more advanced and mathematical way to size your trades is to use the Kelly criterion, which is a formula that calculates the optimal trade size based on your expected return and win rate. The Kelly criterion aims to maximize your long-term growth rate and minimize your risk of ruin. The formula is: K = W - (1 - W) / R where K is the optimal trade size as a percentage of your capital, W is your win rate as a decimal, and R is your reward-to-risk ratio. For example, if you have a 50% win rate and a 2:1 reward-to-risk ratio, the Kelly criterion suggests that you should risk 25% of your capital on each trade. However, this method also has some limitations, such as being sensitive to errors in estimating your win rate and reward-to-risk ratio, and being too aggressive for most traders.

5 Risk-to-reward method

The risk-to-reward method is a practical and flexible way to size your trades, based on the potential profit and loss of each trade relative to your account size. This method allows you to adjust your position size according to the quality and probability of each trade, as well as your risk appetite and trading style. It involves identifying entry, exit, and stop loss levels for each trade, calculating potential profit and loss in dollars and as a percentage of your account, comparing potential profit and loss to desired risk-to-reward ratio, and adjusting position size accordingly. For example, if you have a $10,000 account with a 3:1 risk-to-reward ratio, you can buy a stock at $50 with a stop loss at $48 and a target at $56. Your potential profit is $6 per share and your potential loss is $2 per share. Your actual risk-to-reward ratio is 3:1 which matches your desired ratio. Your position size is 100 shares, which equals $5,000 or 50% of your account. This method enables you to tailor your trade size to each trade and align your risk and reward with expectations and goals.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?