Experienced investors will point to money management—mastering trade size, win/loss ratios and diversification— as a critical skill for surviving in the market. But many traders go for large position sizes without realizing—or misunderstanding—the downside they’re exposing themselves to.
It used to be that the average Forex account in the U.S. was $7000, and traded 1 lot about 20x a month. That’s pretty hefty. Imagine that you’re trading 1 lot every time you trade, and you trade 20 times a month. If you have a 100-pip stop loss, that’s a 17% risk exposure. If you lose those 100 pips, you’re losing 17% of your total portfolio.
No Pain, No Gain?
Traders will tell you that if you risk very heavily, then you have the opportunity to make much more per trade in absolute dollar terms. That’s true if you’re looking at a trade-by-trade basis. But it breaks down when you look at a series of trades. You’re not going to just trade once and roll the dice—you’ll be trading multiple times.
So this is an extreme example, but I think it will illustrate the point. Say you had a $10,000 portfolio, and you lose 20%. Now you have $8000, which you reinvest and gain 20%. That only gives you $9600 in absolute dollar terms. You’d need a 25% gain to break even on your 20% loss.
If the market gives you a streak of losers, that’s an especially bad thing because they can damage your balance a lot faster than your winners can make up for it.
Figuring Out a Position Size that Works
So what is the right percentage of risk, and the right position size for each trade? Unfortunately, that’s one of those things with no one right answer. But conceptually, you should understand that smaller position sizes give you less downside risk, and more chances to make up your losses.
There is a point where you could be risking too little, but for most traders, that’s probably pretty far away from what they’re actually doing.
However, one of the best things you can do now is to test whether you are currently using the “wrong” trade size. Take your trading history from your actual account and begin reducing the trade size in a spreadsheet. Assuming you have been consistent in your sizing, you should be able to easily tell whether you could have performed better with smaller trades.
Although it is attractive to take big risks for theoretically bigger returns, trading too big over a series of many trades will reduce your returns both in percentage terms and in absolute dollars. Take the time to rethink how large your trades are and whether you are just sacrificing performance.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.