Risk is an important factor in trading or investment. Your gain or loss volume largely depends on the amount of risk you undertake. However, financial analysts at PCEX Member advise you to take calculated risk only. Here comes the importance of calculating position sizing.
What is position sizing?
The position size is the number of shares of a stock or crypto you invest in or the number of contracts you buy from the futures market – this is what the definition says. The size determines the risk which, in turn, defines the profit or loss you make on account of it.
How to calculate position sizing?
How will you decide the number of crypto assets or futures contracts to opt for? A bit of mathematics will help you know.
Position size for a trade is obtained by dividing the money at risk or account risk limit by your trade risk.
“Position size for trade=account risk limit/amount of trade risk”
What is account risk?
This is completely a personal aspect. Depending upon your risk appetite, fix a risk percentage or value. It’s the amount of risk you are ready to take. For example, you plan to take a 2% risk on your capital investment, and the amount you have in your trading account is INR100,000, then your account risk comes out as INR2000. While dealing with multiple crypto markets, keep your account risk percentage fixed – this is what experts recommend.
What is trade risk?
The band between your entry point in a trade and your stop-loss level is referred to as trade risk. Stop-less is a hedging technique to prevent loss in trade owing to the fall in the price of the asset you have invested in. It triggers automatically when the price of the asset falls to a threshold. The Stop-loss level helps you customize the trade risk. However, there is a catch. Keeping it too close to the entry point stops you from taking the benefit of profit opportunities when the asset price moves up. However, keeping it close to the exit point makes you highly vulnerable to risks if the asset price falls.
Let’s apply the formula to the example above where we have account risk as INR2000.
Suppose for a crypto market, you entered the trade at INR50 setting up stop-loss at INR35 means willing to endure trade risk worth INR15.
Therefore, the position size= account risk/trade risk
So, 133.33 is the position size, i.e., the number of shares or units that you should buy considering two factors. First, your financial condition and ability to take risks. And, second, the expected market performance.
Position sizing with the Kelly Criterion
When you are investing in a series of trades or creating multiple positions in your futures trade through short straddles or other hedging techniques, you need to be more conscious about the failure and success probabilities. Successful investors to the likes of Warren Buffett and Bill Gross are known to be relying on Kelly Criterion, which is also sometimes called scientific gambling.
Kelly Percentage = W – [(1 – W) / R], Where:
W = Winning probability
R = Win/loss ratio
The descriptions of W and R are as follows:
The win probability, or the probability that any given trade you make will make a positive return
Win-loss ratio, or the total positive trade amounts divided by the total negative trade amounts.
Let’s calculate the Kelly % for the example.
Suppose the winning probability is 60%, and the win/loss ratio is 4.
Then Kelly % comes out to be 50%.
What does it say? It means you can keep your risk appetite at 50 percent. In terms of trade risk, keep the stop-loss level at INR25 and in terms of account risk, keep it at INR50,000.
Due to the involvement of too many probability-based data into Kelly Criterion, some experts often raise alarm on its usage in determining the position size. To make your probability strong, draw in insights from Candlestick charts or other predictive analytics available. The exercise will help you to more accurately analyze the trade risk and market volatility.
Is position sizing critical for all investment types?
Yes. Spot trading (including intraday trading) or futures market – no matter what your trading option is, position sizing matters everywhere. It helps you maximize returns and mitigate losses while trading.
Choose position size wisely and grow your asset.
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