Not Risking Too Much Money on any given trade is essential to succeeding as a day trader. Unfortunately, when most people start Day Trading, they do not think about the risk that they are taking - only about the potential rewards. Every day 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 day trader's ability to limit his losses is just as important (or even more important) as his success in managing winning trades. 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 ""YES.""
Limiting losses when day trading involves a lot of common sense. To begin with, no 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 rule, his chances of succeeding are greatly increased because it will take many consecutive losses to wipe him out and he will have more opportunities to make winning trades. If a trader would be trading 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 losses 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 an example:
Position Sizing Example using Currencies:
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), but is this a wise thing to do? Let's look into this a little further. Let's say that based on his Trading Strategy, the day 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).
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? 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 would 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 in one trade, it is not a smart thing to do so. Trading is all about your probability of survival. To survive, you cannot risk more than you should. Risking too much is not smart money management.
* In general, day traders with less than $10,000 should consider trading with a mini account. A forex mini account can be opened with as little as a few hundred bucks.
Position Sizing Example using Stocks:
(remember that to day trade stocks 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 Day 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 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 in trading is by not taking on a position larger than an account of a given size could 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% rule will keep traders out of trouble and it is simple to apply. It is common sense more than anything else. Don't become another day trading statistic - limit your losses all the time with protective stop orders!
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To Your Online Trading Success,
A Professional Forex and Stock Market Trader
Dan A.
