Amount to Risk per Trade and Position Sizing

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Amount to Risk and Position Sizing

Q.: Why is it important to distinguish between margin and leverage?

A: A challenge for many novice traders in CFDs is deciding how much money to commit to each trade. Some CFD brokers like to tout their competitive margin requirements for stocks to get you to sign up but you shouldn't factor this too heavily as leverage can quickly kill you if you overgear your account.

To illustrate this we will open two positions with a $5000 account size -:

To see what happens when you open multiple positions with different margins we will open a second trading position -:

An inexperienced trader might still be thinking that he has $3,500 available margin for taking on additional positions, however with 4x portfolio leverage, every 1% move the market moves against you, you will lose 4% of your capital so a move of 10% against your total portfolio would wipe out 40% of your account. This is why it is absolutely crucial that you trade with stop loss orders and have a constant position size amount which you are willing to risk.

Q.: How do I calculate my position size?

A: Every CFD trader should have a money management plan linked to his/her capital outlay, essentially this is a system that will make your capital last and enable you to survive losing streaks. Money management is a vital discipline for all traders who wish to give themselves the best chance of success in CFD trading.

Position sizing is one of the most important aspects of managing your risk as it helps you identify the amount of your account balance you are prepared to risk with each CFD trade. New traders tend to focus on the outcome of the trade, overlooking the anatomy of risk factors and the tools to manage this risk. In reality the outcome of a trade is uncertain. The question then becomes: how much can I afford to lose on this trade?

Once you answer this question you will either want to adjust your position size or your stop loss. It is more important to adjust your position size than your stop loss, as the stop loss should be based on technical levels.

Formula for calculating position size -:

risk amount - commission / difference between entry and stop loss level = trade size.

Example:

$400 -10 / 20 cents = 1950 CFDs

1950 CFDs x entry price = Position Size

Let's take another example this time only risking 1% of the pot. If you have an account valued at £10,000 and you want to buy a stock at £12 with a stop loss at £11.90, then the number of shares (position) to trade is:

Position Size = Account Risk / Trade Risk
Position Size = (1% x account value) / (entry price - stop loss)
Position (no. of shares) = (1% x £10,000) / (£12 - £11.90)
£100 / £0.1
Number of shares to buy = 1000 shares

How much should you risk per trade? A common approach is to risk only 2% of your total capital per trade. Some say that this is too much and others say that it's too little, however 2% is a good starting point for risk management if you are having 50% success with your trades. This will allow you to have a run of losses and still have a viable float to continue trading and at the same time, when profits go up 2%, 5%, 10% or more and you have leverage working for you, your profits can soon add up.

Total account size: $10,000
Risk 2% of total account : $200

Q.: To what extent should I gear myself?

A: We know that CFDs are a leveraged product but to what extent should you gear yourself? This in practice is up to you and your strategy but it should depend on your win vs loss and your risk vs reward ratios.

A reasonable position leverage could be a ratio of 1:3, which would allow an account with a capital base of $10,000 to have the buying power of $30,000. Once you establish a successful trading strategy and it is working along well, you may wish to increase your total account leverage further, perhaps to 1:5, where $10,000 can buy a $50,000 position. In this case a 1% increase in the value of a $10,000 position will equal a 5% increase in that of our investment - such is the power of leverage.

For this reason it is important that you are always aware of your esposure. Assuming the stop is say 4% away from the entry price and your account is leveraged 5x, if you have 3 similar trades overall then you are risking 20% on each trade and 60% of your capital on these 3 trades alone. True it can go both ways and you can make extraordinary returns as well but it is more important to protect your money than to chase bigger profits if you are aiming for long term success. Trading is a numbers game and margin trading can be deadly if you get it wrong and you get caught overleveraged.

Let's take BHP as an example -:

The important factor here is to be fully aware of the leverage amount and your financial open trade exposure at any one time.

 ...Continues here - CFD Trading Costs