Risk Management & Position Size
Position Size and Risk Management go hand in hand with each other and are the two most important things to consider before you even begin trading. While most new traders think that "winning" is what trading is all about, they will soon come to realize that losing is far more common. The reality of trading is that you will most likely end the month or year with more losing trades than winning trades. This is why risk management is so important in trading. The entire idea behind our strategy is to allow one winning trade to make up and pay for multiple losing trades. The only way you can accomplish this is by having a set risk, keeping your loses small, and letting your winning trades make up for it.
If I had to, I would guess that position sizing is something that new traders don't even think about. It's a subject that is often overlooked by new traders. The proper position size will vary trader to trader and can depend on the size of your account. While there is a maximum size a new trader should use to prevent catastrophic failure, there is also a minimum size that will ultimately lead to the same demise and failure. If you are a new trader or trader with a small account then this lesson is very important for you.
How much is too small?
One of the first questions a new trader will ask is"how much money do I need to start trading"? Unfortunately there is no direct answer to this question and the amount of capital required will be different based off each trade idea. The first step in calculating capital requirements starts with establishing an understanding of what it cost to make a trade, this should include cost of commissions charged by your broker as well as any fees that may apply. Once we've established what it's going to cost to place a trade we can start to look at risk and reward to determine how much capital we will need for our trade idea.
While at first glance it may seem silly to you that there is actually a position size that is too small. It is not uncommon for new traders to make a correct pick, sell a stock higher than they bought it for, and still end up losing money. Trading is not free and price per trade can vary broker to broker. I most commonly use Fidelity for my broker which charges 7.95 per trade, so we will use this for our cost basis. Now lets say that your just starting out and you only have $500.00 to get started. While it is not impossible to grow a small account, you need to take into consideration that you will be at a serious disadvantage and have next to a zero chance of success. With smaller accounts rules and discipline are that much more important.
You have been watching the ticker symbol EST (not a real ticker) and you are starting to like the price action. EST is currently trading at $2.50 per share. You want to start small so you decide to start using only $100.00 of your total $500 account value. With your $100.00 you can purchase 40 shares of EST. After a couple of days the stock has gone up $.30 per share and you decide its time to cash out on your first winning trade. After earning $.30 per share and having a total of 40 shares you are left with $112.00 or a 12% return. Getting a 12% return on a trade is very acceptable and even above average. Once your money has cleared your broker you notice that your account value has actually dropped by $4.00. You start scrambling to figure out how you just lost money on a winning trade and then you see a big ugly commission fee charge from you broker. In our scenario we are using 7.95 as our cost basis. Your broker will charge you each time you purchase shares and each time you sell shares. The trade above netted you a $12.00 return but the commission fees associated with the trade cost you $16.00 leaving you with a net loss of ($4.00). Many new traders with small accounts will be wiped out simply by commission fees. With that said I am a firm believer in burning commissions to gain experience and knowledge over purchasing any type of online trading course. This positions size is to small and you will need more capital to profit from this scenario.
As any successful trader will tell you risk management is the number one rule you have to follow. It can require extreme discipline and even cause you to miss out on a trade or two. This is a long-term protection plan designed to keep you in the game for as long as possible giving you the best chance at success. There is no need to complicate risk management and were going to keep it simple for you.
You must absolutely never risk more than 2% of your total trading capital on a single trade.
For example if you have a $500.00 trading account, you are only allowed to risk 2% max per trade of that $500.00. That leaves you with a risk of $10.00 per trade. Only risking $10.00 per trade is nearly impossible, if your thinking about trading with a $500.00 account you might want to put this into consideration.
There is no single definitive answer to the question "How much money do I need to trade"? The cost of trading has many variations to it including, account size, risk tolerance, stock price, targer price, stop loss, and will always change with each trade idea. With the cost of trading in mind, we can start to figure out what size of a position we will need. We need a large enough position to cover the cost of commissions when we hit our target and small enough that we aren't risking more than 2% capital if we hit our stop loss. The amount of total capital needed will all be based on your per share price. One winning trade can make up for many losing trades, but only if your using proper Risk Management. I can not stress this enough!