Traders spend a great deal of time building systems and strategies to gain an edge in the market. While finding the best entries and exits are an important part of trading and system building, it sometimes overshadows the more important element of risk vs. reward.
The most successful long-time traders will tell you that what separates them from less successful traders is their risk management. John Henry once said that his trend following entries are not that much different from other trend followers, but that his risk management procedures is what differentiates his strategy.
Position Sizing : The Key to Risk Management
Every trader will have winning and losing trades. The key is limiting losses on your losers and extracting greater value from your winners. A key to this is having the proper position size. No trader will ever consistently buy at the low and sell at the high so having the proper position size is vital.
Popular Position Sizing Methods and Potential Issues
There are several position sizing methods developed over the years but many tend to take on too much risk. The problem with methods such as the Kelly Criterion and the Martingale Method is they often assume unlimited risk capital.
- The Kelly Criterion is a mathematical formula designed to optimize position size. It’s calculated as: K = W – (1 – W) / R, where K = The percentage of your bankroll to risk. W = The probability of a winning trade. R = The ratio of average wins to average losses. While this method offers theoretical precision, it assumes you have unlimited capital—a luxury most retail traders lack. Overusing it can quickly lead to excessive risk and devastating drawdowns.
- The Martingale Method simply doubles your bet size or risk following every losing trade until you ultimately win (or go broke) and then goes back to your initial bet size and starts the process over again. The concept—occasionally used by blackjack players— is logical in a simplistic way but rarely if ever works out.
More Methods of Position Sizing for Retail Traders
While these methods may work in theory, they assume near-unlimited risk capital. Retail traders do not have unlimited capital and these methods will eventually lead to a blow up.
Professional trading coach and founder of KJ Trading Systems Kevin Davey created a simple coin flip analogy, showing how a hypothetical coin flip strategy that produces a $2 profit on every winning trade vs. $1 loss for every losing trade with a 50/50 chance of success will still face risk of ruin with improper position sizing.
While simplistic, the exercise shows the risk of overtrading. Trading 10% of your bankroll would create the possibility of risk-of-ruin despite the 2 to 1 edge. You will never know precisely your total risk so calibrating your position size to match your projected risk is dangerous. Professional traders often say, “Your worst drawdown is always ahead of you.”
The best method for retail traders is to start with one contract and only increase their bet size after building their account. If you trade one contract for a $15,000 account, you can go to two contracts when your account grows to $30,000.
Another method is to limit trades to 1 or 2% of your risk capital.
Any technical based strategy needs to determine a price level that defines a failed trade. If your research sets that level outside of your comfortable loss parameters, that is an indication that you should not take the trade.
For retail traders another good option is the e-micro contracts that trade at 1/10 the size of the e-mini. It gives you flexibility in bet sizing. The smaller contracts allows a trader to take a smaller profit on a portion of the position and then move the stop on the remaining contracts to breakeven and provide the opportunity for a larger return.
Risk management is the lifeline of any trading strategy. No matter how effective your entries and exits, failure to manage risk can result in catastrophic losses. Start small, use flexible tools like e-micro contracts, and always prioritize protecting your capital.
By focusing on proper position sizing and disciplined risk management, you can navigate the uncertainties of trading and position yourself for long-term success.
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