Position sizing helps avoid unnecessary losses.
Position sizing is a trading method to help avoid unnecessary losses, and refers to the size of a position or dollar amount that a trader is going to trade per any one transaction.
A seasoned trader may recommend to “not risk more than 2 percent of your working capital as per each trade.” Let’s be a little more specific about this. There are just three simple steps involved in figuring out how to do this right.
1. Determining a tolerable risk percentage for a strategy.
As just mentioned above, a rule of thumb among investors in the stock market is to not risk more than 2% of working capital. The crypto market is a lot more volatile, so is 2% reasonable, tolerable? How much money is in your working capital, what strategy are you employing? Your call.
For example, the 2% rule would prompt a trader with $20,000 as working capital to not risk more than $400 in any particular trade transaction (2% x $20,000). Let’s call the $400 the Account Risk Amount (ARA). So, if the trader loses 10 consecutive trades in a row, s/he would have lost only 20% of the working capital – in a figure of speech that is.
2. Setting a stop/loss order per each trade.
Don’t invest or trade without considering stop/loss orders, please. OK, the trader now needs to also determine where to place the stop/loss order as per each trade transaction. How much loss can you, as the trader, tolerate in dollars per each trade? The loss amount may not need to exactly match the 2% account risk amount. Are you willing to tolerate a price drop of $20 or $50 or $5? Let’s call this amount the Trade Risk Amount (TRA), that is the spread between your entry point and the stop/loss order. The greater the spread or trade risk amount is, the riskier the trade gets and the fewer shares can be bought.
Again, consider how much skin (money) you have in the game and what strategy applies when deciding on where to set the stop/loss order. If you position trade in slower charts and in a confirmed uptrend, you may be less worried about a dump and go with a looser spread between your entry point and the stop/loss order. If you swing trade in faster charts and in a perhaps “fishy” retracement (bear or bull trap), you should be more worried about a dump and go with a tighter spread between your entry point and the stop/loss order.
3. Calculating the proper position size.
As the trader now has an idea about account risk amount (ARA) and trade risk amount (TRA), s/he can calculate the correct position size. That position size is arrived at by dividing the account risk amount by the trade risk amount.
Here’s an example. A trader got $20,000 to trade with and is are willing to risk 2% of that working capital per a single trade. Then s/he buys, as suggested by the method, 10 ETH at $500 each and places a stop/loss order at $460, which makes the trade risk amount $40 per coin. So, the trader spends $5,000 on that trade. If the price drops unexpectedly, the stop/loss order at $460 triggers and the position gets sold. The trader gets $4,600 back, with a loss of $400. That loss amount is well within the tolerance of 2%.
Had the trader bought 20 ETH instead, s/he would have spent $10,000 on the trade and gotten $9,200 back. That is a loss of $800, or 4% of working capital. If the trader would have been willing to risk a larger drop in price, s/he simply could have bought fewer coins.
“Well,” you might say, “had the price gone up, the trader would have made a lot of money by buying 20 ETH!” Sure, but we are talking about reducing unnecessary losses. Unless a trader does that, many seasoned investors argue, s/he may lose money in the long run.
The outcome of this method breaks down a bit when the price of a whole coin nearly outstrips the working capital, as can be seen in the last Bitcoin example above. With Bitcoin at just under $7,000 (in April 2018, the time of this writing), a working capital of $12,000 barely buys ~1.5 bitcoins, less than the suggested number of coins at 2.4. Note that the calculation does not depend on the amount of working capital.
So what to do now? Don’t worry, the position sizing method is a guideline that helps to rein in your unbridled exuberance. Just buy as many fractions of a Bitcoin, called satoshis, as you can, but set a stop/loss order at any percentage of your choice below the entry point. In very volatile markets, like Bitcoin for instance, a 2% may be too restrictive anyway.
It must be said that stop/loss orders in cryptoland are no absolute guarantee against losing money. In rare moments of increased volatility the price of a coin or token gaps really fast and steep below the stop/loss order. This is called a flash, and by the time the stop/loss order is actually processing to be filled, the price might already be way down. And then it comes up again just as fast, but you are out of your position. Ouch.
Heard of dollar-cost averaging? It is not the same as position sizing although it tries to minimize losses as well. The dollar-cost averaging method requires investing the same amount regularly (typically monthly) regardless of the price of the coin/token to lower the cost per share and reduce the risk of buying at the most inopportune time. It works remarkably well in the context of the long-term buy-and-hold strategy for stocks, etc., that younger folks – starting out with little money – may employ to build their retirement fund.