Position Sizing versus Trading Psychology
The One Percent Rule
Risking 1% of your account per trade means you are always 100 trades away from blowing your account. Trading 1% risk on a positive expectancy setup will give you a smooth equity curve and drawdown’s during a bad trading spell won’t be too uncomfortable that it stops you from taking the next trade. Remember losers can come in groups of 5 or more during bad market periods even for the best methods. Note, if you are getting strings of losers during good market periods your entry criteria is flawed.
Calculating Position Size Using the One Percent Rule
Based on an account size of £100,000 1% Risk = £1000 or 1R per trade is risked at your stop loss.
Subtract your predetermined stop level from your entry price to give stop distance in points then divide your risk by your stop distance and multiply by 100 for the amount of shares you must buy. For a spread account you don’t need to multiply by 100 as Pound per point is the same as 1 Lot (100 Shares)
Stop Level = 100 Entry Price = 120 Entry – Stop = 20 Points. £1000 / 20 = £50 Per Point for a spread bet or (£1000 / 20) x 100 = 5000 Shares.
The Two Percent Rule
A lot of more experienced traders will give you examples of account growth based on 2% risk per trade. They like to give the best growth examples usually to sell you their system. Some very experienced traders are comfortable with this amount but for most traders the draw downs are too big. Risking 2% of your account per trade means you are always 50 trades away from blowing your account. Now add to this a run of 10 losers and you now have a 20% drawdown on your account. You now have to make 25% just to get the account back to break even compared with 11.1% on a 10% drawdown using the 1% rule. Now that’s only half of the problem. Have you got the trading psychology to step back up to the plate and take that next trade when your 20% in a hole? This can lead to another mistake where the trader decides to drop his size after he’s already in the whole and try to trade his way back risking half the size so in effect doubling his task.
The Gap Down, How Much Heat Can You Take
So you have a setup that gives you a defined stop level of 10% and your risking 1% of your account. You wake up the next morning to a profit warning and your stock gaps down by 50%.
You have a 1R £1000 risk stop 10% below the market and it gaps down 50%. You lose 5R or 5% of your account overnight. If you had a 5% stop or you were risking 2% of the account you would be 10% in a hole overnight. add to that a couple more losers and your back to the previous point. Have you got the trading psychology to step back up to the plate and take that next trade?
What Do I Do
On setups like a base breakout that have wider stops I risk 1% of my account and I look to add to winners on a defined second entry setup where I can trail my stop to lock in some heat or profit and add more shares so my new stop is now 1/2R . Obviously I have to be able to lock in more than half an R to free up some heat so I can buy more shares.
This is a very powerful method as it turns a risk 1 to make 2 or more trade into a risk 1/2 to make 2 or more but your 2R distance is now more achievable as you have more shares running so 2R is now closer to your entry. You are skewing the reward to risk in your favour on your winning trades that gave you a defined second entry. Think of it as buying the breakout and adding after the first retrace.
On swing trades with tight stop distances I risk 1/2% (1/2R) on the entry setup and then add to a winner at a defined second entry setup so I have a full position running on winning trades and half the gap risk on trades that are still near my entry. On a great trade with multiple bases I could add to my trade multiple times whilst halving my risk as I lock in profit.
Foot on the Gas Trade
Once in a while a special situation will setup where you have a very defined base breakout setup that is triggered by a raised guidance RNS on a share where guidance was already excellent. This is the foot on the gas trade. This is when I use the 2% rule. special situations that come around every blue moon. Knowing when to step on the gas comes down to experience from time spent in the markets and this separates great traders from good traders.
Risk, Risk, Risk
Profitable trading involves taking many trades that chop around then go nowhere. Small winners then small losers. But you have to take these trades because you don’t know which one is going to be the big winner. The great trade that eclipses all the small trades and moves your account up to a new level. The only way you can have confidence to step up to the plate consistently and take that trade no matter what the market throws at you is if your risk is low enough so that your trading psychology can handle it. You must also know the math of your method inside out and know your expectancy by forward testing through different market environments in real time. When I test a new setup I will trade it at less that 1/2% just to get the results without risking too much money.
Profitable trading is not about being right. its about your winners being multiples of your losers. My most profitable quarter I ever had with my swing trade system also had the lowest win rate. Think about that. The lowest win rate made the most money. Profitable trading is not about getting the lowest price. it is about how many multiples of your entry minus your stop you achieve on your winners compared to your losers and your losers should all be 1R or under.