What is position sizing?

One question before every trade

Position sizing answers a single question: how much? Not whether to buy or sell, not where to get in or out, but how many units, lots or contracts the trade should be.

It is the least discussed part of trading and the one with the largest effect on the account. Entry and exit decide whether a trade wins or loses. Size decides how much a win or a loss changes your balance. A good entry with the wrong size can end an account. An ordinary entry with the right size cannot.

Same signals, different accounts

Imagine two traders following exactly the same rules on the same instrument, say an index CFD. They enter at the same price, place the stop at the same price and exit at the same price on every trade. Over a year they have identical win rates and identical average wins and losses in points.

The first trader risks 1% of the account on every trade. The second risks whatever feels right: 2% on a routine trade, 8% on a trade that looks certain, 15% after a losing streak to win it back.

After a year the first trader’s account has moved in proportion to the strategy’s edge. The second trader’s account has moved in proportion to which trades happened to be the large ones. If the large ones lost, the account is deeply down despite following a strategy that made money. Same signals, same skill, completely different equity curves. Only the sizing differed.

What size actually controls

Three things follow from position size, and none of them from the entry:

• The loss on a losing trade. With a stop in place, size multiplied by the distance to the stop is the loss in currency. It is the one number you decide before the market decides anything.
• The depth of a losing streak. Every strategy has runs of losses. Size decides whether five losses in a row cost 5% of the account or 40%, and the maximum drawdown lesson in the track record series explains why the second is so much harder to recover from than it looks.
• Whether you can keep following the rules. A trade sized so large that a normal loss is unbearable will be closed early, moved, or held past its stop out of fear. The sizing decision then gets made again, badly, in the middle of the trade.

What a sizing rule protects you from

A written rule replaces a feeling with arithmetic. It protects you from:

1. Sizing by mood. Confidence is not information about the market. A rule gives the certain-looking trade and the doubtful one the same risk, because you cannot tell in advance which is which.
2. Sizing by recent results. After losses the temptation is to size up and win it back. After wins it is to size up because it is working. A fixed rule does neither.
3. Unreadable results. If every trade risks a different amount, you cannot tell afterwards whether the strategy has an edge or the sizing got lucky. Comparable risk per trade is what makes a track record readable at all.
4. The one trade that matters too much. With a rule, no single trade can decide the year.

Size and leverage are different things

Leverage is how large a position the broker allows you to open with the margin you have. Position sizing is how large a position you should open. With 1:500 leverage a 1,000 euro account can control a position worth 500,000, and nothing in the platform will stop you. That is why a sizing rule matters more, not less, on a leveraged account: the platform sets the ceiling, and the rule sets the size.

CFDs, futures and options ask the question differently

The principle is the same everywhere. The unit you are counting is not.

• CFDs let you trade almost any size, usually in steps of 0.01 lot, on gold, indices, currency pairs, shares and commodities alike. The size can be matched to the stop almost exactly, which is why the arithmetic in this series is written for CFDs first.
• Futures come in fixed contracts set by the exchange. A gold future on COMEX is 100 ounces, its micro version 10 ounces, and there is nothing in between. Size is a whole number of contracts, and for a small account the honest answer is often zero. Contracts also expire, so a position has a date as well as a size.
• Options change what risk means. A bought option can lose at most the premium paid, so the position is sized by premium against risk amount and no stop is required. A sold option has the opposite profile, with a limited gain and a loss that can exceed the account. The same 1% rule applies, but the number it is applied to is different.

The third lesson works through the arithmetic for each.

Why this matters if you copy trades

When you copy a strategy, its sizing rule is copied too, scaled to your own account by the copying settings. You never type a lot size yourself. You still need to understand the rule, for two reasons. It is what decides how a drawdown in the strategy turns into euros in your account. And it is the first thing to check in any track record, since a beautiful curve produced by sizing up after losses is a curve waiting to break.

What the next lessons build

A sizing rule needs two inputs. The first is how much of the account you are willing to lose on one trade, which is the subject of the next lesson. The second is the distance from your entry to your stop, which turns that amount into a number of units. The third lesson puts them together, in euros, with the arithmetic shown for gold, an index, a currency pair, and then for a future and an option.