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Trading basics: Use this strategy to protect your trading pot from a catastrophic loss

by , 06 January 2015

Trading can reward you handsomely. But don't let the potential gains let you put too much money at risk on one trade.

You need to protect your capital. One of the best ways you can do this is through position sizing.

So what is position sizing? And how can you use position sizing when you trade?

Read on to find out…


What is position sizing?


Position sizing is a trading strategy that you can use to calculate how much money to put into an individual trade.

The first thing you need to do is work out how much of your trading capital to risk on one trade. A common percentage is 2%. But you could opt for 1% or 0.5% depending on your attitude to risk.


How to use position sizing when you trade


To illustrate how position sizing works, let’s look at an example…

You have a trading pot of R50,000, Brian Hunt in The Crux explains. You’re thinking about buying Company ABC at R20 a share.

To work out how many shares you buy, you use position sizing. You need to work out how much money you’re willing to risk on this one position.

To calculate this, you need to know just two things:

  1. How much money you have in your trading account; and
  2. How much of your account you’re willing to risk on one trade.

You decide to risk 1% of your R50,000 trading pot. That works out at R500 for the trade. You decide you’ll run a 25% stop loss.

To work out how many shares to buy, you do the following:

  • Divide 100 by your stop loss (100/25 = 4).
  • Take that number and multiply it by your amount to risk per trade (4 x R500 = R2,000).

For our example, that’s 100 shares. If the share falls 25%, you’ll lose R500 and exit your position.

Of course, you could opt to run a tighter stop loss of say 10%. A tighter stop loss means you can buy more shares, but you’re still risking the same amount of your trading capital.


Using position sizing with derivatives


If you opt to use derivatives, like options, you can still apply the same position sizing principles.

Say you buy call options on Company ABC. Each option is R2. As options are based on the underlying single stock future, which is based on the underlying shares, the contract size is 100 shares.

One option contract will cost you R200.

You opt for a 20% stop loss. Here’s how to calculate your position size this time…

  • Divide 100 by your stop loss (100/20 = 5 options contracts).
  • Take than number and multiply it by your amount to risk per trade (5 x R500 = R2,500).

If the trade hits your stop loss, you’ll still stand to lose R500.

You can use this strategy to any sort of trade you put on. You’re risking the same amount of money each time.

So there you have it, a trading strategy to protect you from a catastrophic loss.

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Trading basics: Use this strategy to protect your trading pot from a catastrophic loss
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