Exposing a Trader's Blind Spot - The Most Overlooked and Critical Aspect of Trading

Traders know that position sizing is important, but because it requires some math calculations and some extra effort many traders simply use a fixed trade quantity for all trades. Why would you trade the same 100 share trade quantity for both a $20 and a $150 stock? That is not smart position sizing. Why would you trade a fixed number of shares for both a 5 minute chart and a 60 minute chart? That is not intelligent risk management. This lazy man's approach to position sizing, which negatively impacts your risk management, doesn't make sense! In fact, it is sheer foolishness and a good way to waste money in your trading account. Read on to learn how to do position sizing and risk management correctly.

Why position sizing is so vital is summed up by Perry J. Kaufman in his book, New Trading Systems and Methods; "A trading system alone will not insure success without proper risk control beginning with individual trades... therefore the size of the position, the markets to trade, and when to increase or decrease leverage becomes important for financial survival." As Mr. Kaufman points out, risk management via proper position sizing done on a trade by trade basis is vital to your trading account survival. Since we know that a fixed trade quantity is the worst model possible, let's look at something that is viable.

The "fixed risk amount and volatility" position sizing model is good and fairly simple to implement. First, figure your fixed risk amount. In this article our example uses stocks but everything we cover applies to Forex and futures trading too. Let's use a trading account balance of $30,000 multiplied by 1% of the account balance which equals $300 for your "fixed risk amount" on each trade. The reason it is called a "fixed risk amount" is because you use $300 to your stop loss price on every trade you make. Second, to establish the volatility aspect, you will use either ATR (average true range) or Range (high minus low). Take some multiple of this range, like 2 or 3, and that becomes your stop loss price. The distance from your entry price to this range multiple stop loss price is your volatility buffer to keep you in the trade yet give the symbol enough wiggle room to not get stopped out of a good trade entry. Although it requires some effort this is a good position sizing method, but there's something even better. Read on.

For the most advanced position sizing model we recommend using a "fixed risk amount" divided by the "real trade risk amount." Basically we are replacing the generic "volatility" risk amount calculation used in the first model with the "real trade risk amount" to create the best money management position sizing method possible.

We already covered the "fixed risk amount" calculation in the first model, so we will use the same $300 "fixed risk amount" for this advanced model. But now instead of a generic volatility calculated risk amount we are going to calculate your "real trade risk amount." What do we mean by your "real trade risk amount?"

Let's look at an example using a long trade entry set-up to illustrate the "real trade risk amount." First we decide where both the entry price and the stop loss price should be. That distance from the entry price minus the stop loss price is the "real trade risk amount" per share.

The "fixed risk amount and volatility," which was our first model, calculated a volatility based stop loss risk amount; but for this advanced model, we recommend using real time fractal support and resistance to determine where to position the stop loss price. For this long trade example you'll look for the last down fractal, which is defined as where the price was going down for several bars then turned around and went back up for several bars. This down fractal represents the most recent price support (where price actually reversed directions), so let's use this price minus a few extra ticks as our trade stop loss price. In other words, if you are going to make this long proposed trade you want the price to remain above that last down fractal price which represents support. Otherwise if price drops below this support you don't want to be holding a long trade.

Now to calculate the "real trade risk amount," subtract the proposed entry price minus your last down fractal price minus a few extra ticks. To put this advanced model calculation all together take the $300 "fixed trade risk amount" and divide by your "real trade risk amount" per share to give the specific trade quantity for each specific trade. This advanced model calculates the maximum possible shares you can trade on each individual trade.

This advanced position sizing model is far superior to most other forms of position sizing. If you are daunted by the math or the extra time and effort this will take, you'll want to look for computerized tools that can automatically do this math for you and make your trade risk management very simple.

The best and most consistent traders have strong risk management skills. Be a wise trader and intelligent risk manager with your trading account. Make use of this advanced "fixed risk amount" divided by the "real trade risk amount" position sizing method to maximize your trading profits on each individual trade.