US$50 of risk per trade can quickly seem manageable depending on the account size – in a trading account with an available trading amount of US$10,000, this is only 0.5% of the account. However, those US$50 become a useful limit only when the position size matches the distance to the stop-loss.
Anyone who buys an arbitrary number of units and only then places the stop-loss at an arbitrary point on the chart has not calculated the risk and has simply left it to the market. Position size combines three important figures: account balance, maximum accepted loss and the price level between entry and stop-loss. Depending on the trading instrument, leverage can also change the required margin and thus have a considerable impact on the actual risk.
Calculating Position Size Means Limiting Losses.
The basic formula is actually quite simple and easy to apply:
Position size = maximum monetary loss ÷ risk per unit
Risk per unit is derived from the price level and therefore from the distance between entry and stop-loss. Here is an example:
- Account balance: US$10,000
- Maximum risk: 0.5%
- Permitted loss: US$50
- Entry: US$100
- Stop-loss: US$98.50
- Risk per unit: US$1.50
US$50 ÷ US$1.50 = 33.33 units
Under these assumptions, the position could therefore contain no more than 33 units. The calculated price risk would be US$49.50.
The example initially leaves fees and slippage out of account. In practice, however, both must always be taken into consideration. Position size should therefore not simply be rounded up to the mathematically maximum number of units. Instead, a small buffer must be included in the planning so that the position still corresponds as closely as possible to the trader’s own risk parameters after the first price deviation.
The order of this process should therefore be clear: first determine the maximum accepted loss, then define the price level for the stop-loss, and only after that calculate the actual number of units.
The Stop-Loss Always Belongs to the Plan
It is important that a stop-loss should never be placed blindly in the chart or simply after a certain monetary amount or number of ticks. It should always be placed at a point where the original trading idea is no longer valid and the trade would no longer make sense. Placing the exit for the loss above or below that point risks requiring several entries or simply accepting a larger loss. Anyone trading a support level, for example, can place the stop-loss below that zone. If the support is clearly broken, the assumption of stable demand has been disproved. The stop is then technically placed correctly.
This creates a practical problem: a stop-loss that is too tight mathematically permits a larger position, while a wider stop-loss leads to a smaller number of units and therefore theoretically has to run longer to reach the profit target with a healthy risk-reward ratio. Many inexperienced traders reverse this process: they first choose a large position and then set a tight stop so that the potential loss appears to fit.
This can cause normal price fluctuations to close the position already. A stop placed directly behind a random small movement does not protect against mistakes. It merely often ends the trade before the actual trading idea has had a chance to develop.
Leverage Does Not Make the Position Safer
Using leverage always changes the required capital commitment. A position with a higher market value can be opened with less equity. This should never be viewed as a way to limit risk, but as an amplification of the price movement relative to the money invested. With an unleveraged security, a price decline of 1% means approximately a 1% loss on the position as well. With a leveraged product, the change relative to the invested capital is significantly larger. Depending on the product, financing costs, knock-out levels or other rules may also apply.
The calculation should therefore always be based on the actual position and the potential loss. Looking at the required margin is not enough. Here is another example:
- Market value of the position: US$5,000
- Capital invested: US$1,000
- Price movement against the position: 2%
The initial loss on the market value is US$100. Relative to the US$1,000 of invested capital, that is already 10%. Depending on the product structure, additional costs or a rapid price movement can make the actual loss higher. Leverage should only clarify how much capital is tied up in a position, while position size determines how much money can be lost in a particular price movement. The two must not be confused!
Slippage Makes Everything Worse
A stop-loss is often treated like a fixed selling price. In practice, however, that is not the case, especially when markets are thin or movements are fast. The next available price can then be significantly worse than the stop level was actually intended to be. A price gap skips price ranges, and if the stop lies in such a range, it cannot be executed at the desired price. A stop at US$98.50 might then be executed only at US$98 or even lower. The previously calculated risk becomes larger. With CFDs, the spread must also be taken into account, because buying and selling prices can be far apart depending on the trading venue, time and liquidity.
This changes the real risk:
real risk = price risk + fees + spread + possible slippage
Several Positions Hide the Risk
A single position can remain within the defined risk. Several similar positions can nevertheless increase the total risk considerably. Anyone trading several companies from the same sector at the same time is not betting on independent opportunities. An industry announcement can move all positions simultaneously. The same applies to several trades on the same index or currency.
Several positions in different products can also represent the same economic bet. A leveraged index trade and several individual positions from that index may appear separate, but they react to the same market factor.
Calculating each trade is therefore not enough. An additional overview is necessary:
- the risk of each individual position
- the total open risk
- shared industry or market risks
- potential losses in a strong adverse movement
- the sum of all fees and financing costs
A position with a risk of US$50 does not automatically remain small when five similar positions are opened at the same time. Five supposedly separate decisions can create a combined risk of US$250.
The 1% Rule Is Not a Law of Nature
Trading advice often recommends risking no more than 1% of the account per trade. This rule can serve as a calculation example, but it is neither a guarantee of capital preservation nor a scientifically proven optimal limit.
With an account of US$10,000, 1% risk equals US$100. Ten losses would mean US$1,000 with a constant dollar risk. If the losses are calculated from the current account balance each time, the decline is smaller. In both cases, a losing streak remains financially significant.
Lower risk per trade slows the potential loss, but it does not make a poor strategy profitable. Anyone who trades with negative expectancy over the long term will lose even with 0.25% risk per position in the long run – just more slowly.
What Happens After a Losing Streak
After several losses, there is often a desire to make up the decline quickly. That is precisely when position size is often increased. A fixed risk turns into an emotional attempt to bring the account back to its previous level. Mathematics and stochastic principles work against this decision. A loss of 20% requires a gain of 25% to be recovered. A loss of 50% requires the remaining capital to double. Anyone increasing position size after a loss increases the distance from the original account balance. A poor trading phase then becomes not only longer, but more expensive.
A written daily or weekly limit can prevent a losing streak from turning into an uncontrolled decline. Returning to a demo account or taking a longer evaluation break can also make sense if the original position size is no longer being followed. At the end of the day: a trading journal is the be-all and end-all of trading!
