There are many aspects to issuing a single trade, you have to know when to enter and exit? how to manage the open position ? etc.. One very basic aspect of a trade is pre-determining the risk inherent in that specific trade. There are many definitions to the word risk in the trading world, of all the professional jargon, this word specifically has many interpretations , I wish there was a “Trading Dictionary” for every trader so we all speak the same language, until someone comes up with this dictionary ,I will define the term “Risk” in the context of this article as this: “The maximum pre-determined amount of loss per trade”, meaning , before you enter a trade you have to know what is the maximum loss you are about to have in case the trade moves against you, this is a significant part of a trade and is as important as entry/exit rules or any other aspect of the specific trade you are about to execute.
How to calculate position size?
So how do you calculate the position size per trade, which is the outcome of the maximum loss in a specific trade?
The risk is determined as an absolute dollar amount you are willing to lose in that trade, for example, you may define that you are willing to lose on a specific trade 50$, this means that if the trade goes against you, you lose 50$ and not more. This has direct implications on two trade aspects – the position size and the position dollar amount.
Once you pre-determine the risk per specific trade, you need to calculate the position size, before you send it to the broker, the position size is calculated as follows:
Position Size = Pre-Determined risk / (current price – stop loss)
Explaining the formula
Let’s break the formula step by step
Current risk – Stop Loss is the distance, in dollar amount, between the current price and the stop-loss price, this means that it’s the absolute dollar amount value of loss per 1 share.
For example, if stock XYZ is trading at 50$ and the stop loss is set to 45$, the distance between the two is calculated as :
50$ – 45$ = 5$
And is 5$, meaning that the max loss per one share is 5$,
Now if the entire, Pre-Determined, loss for the whole trade is the set as the dollar amount that you plan to lose if the trade moves against you, then let’s divide that Pre-Determined dollar amount for the entire position, by the loss per one share to get the Position size.
For example, if you plan to lose maximum 800$ for the entire trade and, in the previous example we saw that the loss for one share is 5$, then we divide the Pre-Determined loss for the entire position by the Pre-Determined loss for one share , which is in our case 800$ / 5$ = 160, this means that if we bought 160 shares of XYZ at 50$ and the price drops to 45$ (losing 5$ per share) , since we bought 160 shares, this comes out as –5$ X 160 = –800$
Predetermined risk values set a crucial aspect of a new trade, it sets the maximum loss per trade by telling a trader how many stocks to buy and what’s her invested amount in a specific trade, after the trade is open with the appropriate stop loss in place , a trader may set the correct position size and most importantly manage the portfolio risk !
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