Risk Management Part 2: Risk vs Reward and Position Size

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Position size, entry, stop loss and amount risked per trade should be relative to each other. Understanding how these are connected and being disciplined enough to incorporate this into your trading system and actually follow it on every trade will be a turning point in your trading career.

In this formula there must be a fixed variable and for me it is amount risked. In 5 minutes once you’re done reading this you’ll know why.

There are 5 steps you need to take to measure your risk and determine position size.

Step 1: Deciding on your account balance

The first decision to be made is how much capital you are going to dedicate towards trading. This is entirely up to you but there are 2 basic rules I urge you to follow:

1. Only trade with money you are willing to lose. If you trade with money you need for basic necessities you will naturally be emotionally attached. This will cause you to make poor decisions. You should never “need” to make a trade. If you find yourself in this position, take a step back and reevaluate your decision to trade with the amount of capital in your account.

2. Start small when you begin trading. You will make mistakes and you will lose money. It’s better to blow up a small account first. I firmly believe in skin-in-the-game over paper trading, even if it is just a tiny amount to begin with. The psychological difference between the chance of losing $0 versus the chance of losing $10 is significant and adds the emotional side of trading into the experience.

Step 2: Determining Risk

Now that you have decided on your account size, the next step is determining how much you’re willing to lose on each trade. Yes — you’re going to lose money. Losing trades are the cost of doing business as a trader and the sooner you become comfortable with this fact, the sooner you will be able to take trades from a position of confidence. Creating consistency around the amount you risk per trade also creates consistency with the feelings (or lack thereof) that you manage with each trade.

A good starting place is to risk 1–2% per trade. For an account balance of $10,000 risking 1% per trade, the most you can lose each trade would be $100. This amount lost per trade should not concern you. If it does, this is a clear sign you’re risking too much and should decrease the amount.

Step 3: Entry and stop loss

Your entry and stop loss should be determined by the chart, not your PnL or a random %. The topic of entry could be a few articles itself so we’ll leave that for another day. For details on where to set your stop loss see part 1 of this series.

Step 4: Evaluate R/R

The beauty and the curse of trading are that you have complete freedom to make any choice you want. There are no hard stops built in to tell you your logic is flawed or a certain trade is not worth taking. One of the most important choices we control is which trades we take and which we do not. Once your entry and stop loss are chosen, you’re able to calculate your risk/reward or “R”.

Risk / reward = R = The maximum multiple you can gain relative to what you risk

If you are risking 2% of your $10,000 account balance and your setup is a 3R trade, meaning your target is 3 times the distance away from your entry as your stop loss, the maximum potential gain is $600.

The easiest way to calculate this is on www.tradingview.com using the “Long Position” or “Short Position” tool.

 
R_tool

Once you’ve determined your R you must decide if the trade is worth it to you. I recommend not taking any trades below 2R, especially in Crypto. Personally, I aim for 3R and above.

This means for every winning 3R trade, I can have 2 losing trades and still be profitable. I only lose 1R per losing trade but gain 3R for every winning trade.

Winning trade = +3R
Losing trade = -1R
Losing trade = -1R

= +1R

By choosing my setups carefully and only taking trades that have the potential to earn me a minimum of 3 multiples what I’m risking, I can have a depressing 33% win rate and still be profitable.

win_rate

This concept is why risk management is the driving focus behind profitability in trading. Second is the ability to manage your emotions and last is your analytical ability.

Step 5: Calculate your position size

Once you know your entry and stop loss you’re now able to calculate your position size. Below is a simple formula for calculating position size.

(Total trading capital x %risk per trade) = $amount risked =

(Entry — stop loss) / entry = %difference = Position size in $ value

Here is a free position size calculator I made. Make sure to copy with formulas onto your own sheet so it works properly.

Remember we’re keeping the amount we risk of our portfolio consistent for every trade so the wider our stop loss is from our entry, the smaller our position size will be.

Example: With a $10,000 account risking 2% per trade with a stop loss 2% away from our entry, our position size is our entire account. If our stop loss was 5% away our position size would be $4000.

We can see that the tighter our stop is the larger our position can be which in turn will produce larger gains through higher R if the trade moves in our favor. This is one reason I obsess over entry. This doesn’t mean arbitrarily move your stop loss tighter so you can “gain more” though. Your stop should always be at the point your trade is invalid.

Once you are able to consistently apply this process to your trading strategy you should see smaller losses, and if you’re being strict about the setups you take, less of them as well.