Regardless of how large the portfolio is, risk management must be applied correctly. Otherwise, the account can quickly become depleted and suffer significant losses. Weeks or even months of progress can be undone by a single, poorly managed trade. A fundamental goal when trading or investing is to avoid emotional decisions. Financial risk is associated with it, feelings will play a big role.
You have to be able to keep emotions under control so that your trade and investment decisions are not influenced.For this reason, it makes sense to come up with rules and follow them while trading.
Define the rules of your own trading system:
What is the personal risk tolerance?
How much capital can I risk?
I could think of many other rules, but we will focus on one specific aspect - how to evaluate positions in individual trades. To do this, we first need to determine how large the personal trading account is and how much one is willing to risk for a single transaction.
3.1. Determin the size of the account
Although this may seem like a simple, even superfluous step, this one is worth considering. Especially if you are a beginner, it can be helpful to use certain parts of the portfolio for different strategies. In this way, you can track your progress more closely through different strategies and also reduce the likelihood of risking too much.
As an example, one trusts the future of Bitcoin and opens a long-term position stored on a hardware wallet. It's probably best not to think of it as part of trading capital. In this way, determining the size of the account is simply an analysis of the available capital.
3.2. Determin the risk of the account
The second step is to determine the risk of the account. You have to decide what percentage of the available capital is willing to risk for a single transaction.
The 2% rule
In traditional finance, there is an investment strategy called the 2% rule. According to this rule, a trader should not risk more than 2% of his personal account for a single trade.
Furthermore, it explains what exactly this means, but first this should be adapted to the volatility of the crypto market.
The 2% rule is a suitable strategy for only a few positions in the long term. It is also usually adapted to less volatile instruments than cryptocurrencies.
For active traders and especially for beginners, this could be the salvation from failure.
3.3. Determin the risk of the trade
This is a crucial aspect and applies to almost any strategy. When it comes to trading or investing, losses will always be part of the game. This is a certainty. It's a game of probabilities - even the best traders are not always right. Some traders may fail much more often than they succeed, and yet they will be profitable.
How is this possible? It depends on the right risk management to have a trading strategy and to observe it.
Therefore, each Tade must have an invalidity point. Here we say: "The original idea was wrong and one should step out of this position in order to mitigate further losses". On a more practical level, this only means where we place the stop-loss order.
The way in which this point is determined is entirely based on the individual trading strategy.
The invalidity point can be based on technical parameters, such as a level of support or resitance. It could also be based on indicators, a disruption in the market structure, or something else entirely.
There is no one-size-fits-all approach to determin one's personal stop-loss order.
It is a matter of self-determination which strategy suits each person.
3.4. Calculation of position size
So now we have all the prerequisites we need to calculate the size of the position.
Let's say we have a $10,000 account. We have found that we do not risk more than 1% for a single transaction. This means that we cannot lose more than $100 for a single transaction.
Let's say we've done the market analysis and found that our trade idea is 5% invalid from our original entry. If the market turns against us by 5%, we exit the trade and accept the loss of $100.
In other words, 5% of our position should be 1% of our account.
Formula for calculating the size of the position :
Account size – $10,000
Account risk – 1%
Invalidity point (distance to stop loss) – 5%
The position size for this transaction is $2,000
By following this strategy and exiting the trade at the invalidity point/stop-loss order, one can mitigate much higher potential losses.
In order to exercise this model correctly, one must take into account the trade fees that are paid for it.
Key Points :
Position size calculation is based on determining the trade risk and determining the invalidity point before starting a trade.
An equally important aspect of this strategy is implementation. Once the position size and invalidity point have been defined , they do not need to be changed once the transaction is active.
NOTE : the material above constitutes chapter 3 of the "Basic trading strategies" course that will be available to purchase in full starting 1st of October.(RO/EN/DE)