When trading in the stock market, position sizing is where all the tools of money management come together. It is perhaps the most important part of your stock market money management rules. Position sizing is simply deciding how much you are going to enter any one stock market trade. You can calculate your position size with the other tools of stock market money management, your maximum loss and your stop loss.
But, many stock market traders think that they are doing an adequate job of standing sizing by just having a stop loss in place. Even though this will tell them when to escape a stock market standing, and will, with a maximum reduction, ascertain how much capital they are risking, it will not answer the question of how much or how many units they can purchase.
If you have already calculated your maximum loss and your stop loss, you can take these values, and plug them into a formula that will calculate how many shares you can purchase without exceeding your maximum reduction. Although it’s easy, the formula I’m about to give you is extremely powerful. The amount of shares for your position is equal to your maximum reduction divided by your stop loss size.
You are already familiar with what a maximum loss is; but may not be comprehend the term stop loss size. A stop loss size is the difference between your entry price and your stop loss value. In the event you were to enter the stock market using a one-dollar trade and set your stop loss at 90 cents, the stop loss value are the difference between your entry price and your stock price, ten cents. As soon as you’ve entered these values into the formula, you can calculate how many shares you need to purchase so that you never risk more than your maximum reduction.
Let us look at how the formula works in practice. If your trading float was $20,000, and you’re risking 2%, your maximum loss would be $400. If your stock market entry price was one dollar, and your stop loss value was 90 cents, your stop size could be ten cents. Now, the amount of shares is equal to your maximum reduction divided by your stop size. In this example, you can purchase 4,000 shares. If this inventory reaches your stop loss, and you have to leave the place, you know you are not going to risk or lose more than 2% of your float, which will be $400.
This formula ensures that the safety of your trading float. A little finessing that a few of my customers like to do would be to class their brokerage fee as part of the maximum reduction.
You can do this by subtracting the stock market brokerage fee in the maximum reduction. If the stock market brokerage fee was $40 for your return trip, subtract 40 dollars from the maximum reduction. Instead of entering $400 to the formula, you would now enter $360. When this is computed out, you can determine how many shares you would buy, and understand that you had contained brokerage as part of your maximum reduction.
By setting your position size so that you comply with the 2% rule, you are using a strategy that will restrict the size of your losses during losing streaks. When you encounter a winning streak, your position sizes will increase at a similar manner. By changing the amount of capital you are deciding to risk, you are going to change the characteristics of your risk to reward ratio. All your stock market money management rules will work together to make your trading strategy as profitable as possible.