Position sizing answers the question - how much quantity should you buy of a stock.
The answer is crucial to risk management.
Determining how much of a currency, stock or commodity to accumulate on a trade is an often overlooked aspect of trading. Traders frequently take a random position size; they may take more if they feel "really sure" about a trade, or they may take less if they feel unsure. These are not valid ways to determine trade size. A trader should also not take a set position size for all circumstances. Many traders take the same position size regardless of how the trade sets up, and this style of trading will likely lead to losses over the long run.
Position Size is determined by your stoploss and risk per trade
Stoploss: Let us look at how position size should actually be determined. The first thing we need to know before we can actually determine our position size is the stop level for the trade. Stops should not be set at random levels. A stop needs to be placed at a logical level, where it will tell the trader they were wrong about the direction of the trade. We do not want to place a stop where it could easily be triggered by normal movements in the market.
There are various ways to determine a stoploss. It can be the low of last bar, last week's low or based on ATR (average true range) or even a fixed percentage (eg. 5%).
Risk per trade: Once we have a stop level, we can now start to determine our position size. The next thing we need to look at is the size of our account. If we have a small account, we should risk a maximum of 1% of our account on a trade. The percentage of the account we are willing to risk is often misunderstood, so let's look at a scenario.
Assume a trader has a Rs.100,000/- trading account. If the trader risks 1% of their account on a trade, that means the trader can lose Rs.1,000/- on a trade. This amount is the risk per trade. In other words, if a trade goes wrong, you will lose only Rs.1,000/- from your original capital.
Calculating position size:
Quantity to trade = Risk per trade / (Purchase price - Stoploss).
Eg. You want to buy a stock trading at Rs.100/- with a stoploss Rs.90. The quantity you should buy is 1000/(100-90) = 100 shares. You are investing Rs.10,000/- and if your stoploss gets hit, your maximum loss will be Rs.1.000/-.
Another example. In above example, say the stoploss is Rs.95. The quantity you should buy is 1000/(100-95) = 200 shares. You are now investing Rs.20,000/- and if your stoploss gets hit, your maximum loss is still Rs.1.000/-.
It is obvious that with every stoploss your trading capital is reducing by Rs.1,000/-. After 80 consecutive losses, you still have Rs.20,000/- left! In reality, a good mechanical system should give excellet profits in your 2nd or 3rd trade itself (unless the stock is rangebound in which case it will be obvious).