Percent risk method

The "percent risk" method of position sizing is the most effective way of determining how many shares to trade. This calculation ensures that risk can properly managed with a share size large enough for winning trades have meaningful impact on account growth.

The calculation is very simple and has the following components:

• Entry price

• Stop price

• Risk amount as a percentage of account value

Example 1 

XYZ is trading at $100 per share.  There is a trade setup showing a potential target of $130 and a failure point at $95. This means that the potential reward is $30 per share and the calculated risk is $5 per share. This gives a reward:risk ratio of $30/$5 or 6:1.

Assume a trader has an account value of $100,000 and has decided to risk 1% of capital, or $1,000 per trade.  The trader would buy 200 shares of XYZ at a price $100 per share with a stop set at $95. 

200 shares times $5/share risk = $1000 or 1% of total account value. 

If the trade is closed at the target price of $130 then a profit of $6000 is achieved. ($30 profit per share X 200 shares)

If the stop loss is triggered at $95 then a loss of $1000 is realized. ($5 loss per share X 200 shares)

-SPECIAL NOTE- Setting a stop price does not guarantee execution at that price and it is possible that a worse price/bigger loss is realized. This will be examined in much more detail in a future article.

Sizing positions this way means that each trade represents an equal amount of risk.  This allows for quick risk management calculations and decision making when formulating a trade game plan. 

The sizes need to fit the traders overall system and risk tolerance and can be adjusted based on specific trade objectives. 

Example 2

A trader may want risk 2% on A+ trade setups and only 0.25% on less attractive trades. This can be adjusted or broken down into tier sizes.

• Tier 1 = 0.25% of account value

• Tier 2 = 0.50% of account value

• Tier 3 = 1.00% of account value

• Tier 4 = 1.50% of account value

Then different tiers can be the default sizing for different trade types; A+ swing trades may get a Tier 4 position size while very short term day trades take less risk with a Tier 1 position size.

Furthermore, using tier sizes aides in selling partial positions to realize some profit while reducing risk, and trailing stops as share price increases.

Finally, percent risk position sizing allows for quick and accurate calculations of total account risk. Five Tier 3 positions would mean that a total of 5% of account value is at risk.

A deeper look at stop orders, tier sizes, selling partial positions to cover risk, and trimming and trailing is coming in a future article.