Position Sizing and Risk Levels

Do you have a clearly defined risk management approach before you enter into a new trade? Have you ever experienced getting into a trade, being shaken out, to see the market going in your direction afterwards without you? These are all day-to-day traders’ challenges.

In this article, we’ll talk about how we define our risk for each trade and understand the role of risk and stop loss in determining the optimal position size for your trade.

How do we apply Risk Management?

Below we have a daily chart of Pantoro limited (ASX: PNR). The price action is setting up for an entry within several days, as the stock broke out above the upper boundary of the descending triangle. We will look at a couple of previous potential trade setups (see the circled areas) and see how we would manage the risk if we traded them.

 

The most important elements of managing risk are the key levels for the trade and the price action.  You use the key levels to determine your total risk on the trade (distance between your entry and stop loss).  You then combine this with the dollar value of what you’re willing to lose per trade to determine your position size.  This method of detemining position size will ensure you maintain a set risk per trade which will help protect your capital over the longer term.

Whenever we get into a trade, we must know where we’d be proven wrong.  We use the key price levels with the price action around them to detemine how we place our stop-loss.

Managing risk in momentum setups

Let’s look at two momentum setups in the PNR chart below. We use EMA (20) to identify momentum and buy when the EMA is growing with the price, preferably staying above the indicator. It doesn’t matter what kind of Moving Average you’re using as long as it helps you stay on the right side of the market.

To learn more about using EMA’s in your trading, go to Increase your win rate with Exponential Moving Average

The setup “1” (see the chart below) starts with the up-move that turns into a pullback, staying above the EMA. Once we get the local high of the momentum up-move (in the case of PNR, it’s around 0.155), we want to box up the price area of the pullback (see the grey area of the setup “1”).

Although we don’t know the low of the pullback in real-time, we can define the high, which would be the trigger for our long entry. As the pullback declines lower, you can adjust the box accordingly.

We buy when the price goes above the upper boundary of the box. We set our Stop-loss below the down border of the box.

In the chart above, the horizontal red line representing the Stop-loss is essentially the price that, if reached, proves that the direction of the market is not upwards, and there is no reason for us to hold a long position anymore.

How to set a proper Stop-loss?

Often traders focus too much on the dollar value and the risk-to-reward ratio when measuring the risk of a trade. Let’s say a trader is willing to risk $500 for the setup “1”. Depending on the position size, it may happen that the trader’s Stop-loss would turn out to be set somewhere in the middle of the box, not below the lower boundary.

If we look closer at how the market started to break out the box (Setup “1”), we see that the price slightly pinched above the boundary and continued the trend in a couple of days. The price could also chop down around the middle of the range and continue the trend shortly after. The trader that based the Stop-loss on the dollar value could be easily shaken out from the position, while the trend-continuation setup remains viable.

Make sure you set your stop loss at the price that objectively disproves your trading idea. This will determine the risk on your trade as the distance between the entry point and your stop loss point.  This risk level will determine your position size. For example, if you risk four cents for a setup and plan to risk $500 per trade, you calculate your position size as total risk per trade ($500) divided by the trade risk (4 cents)  Position size in this example should be 500/0.04=12,500 shares.

The last thing you want to do is set a stop-loss at the wrong place based on your risk per trade.  This is likely to waste away your capital due to normal market volatility while your trade is still valid.

How NOT to set a Stop Loss

 

Let’s have a look at the setup 2.

Suppose we bought on the breakout of the white candle in the grey rectangle at 21c.  If we took the approach that we wanted to buy 10,000 shares and only wanted to risk $200 per trade based on our risk management strategy, we would set the stop loss at 19c as shown above (10,000/200 = $0.02).  The next day, the market broke up higher and then retraced back, shaking us out of the position. The market still stayed within the pullback’s main box that has its lower boundary at 0.18, which’s shown with the dotted line, and then moved higher.

Our trade analysis was still valid and should have resulted in a win if we had set our stop loss based on our analysis at 0.18.  The dotted line is the level where we’d be proven wrong based on the price analysis and is the most appropriate position for our stop loss for this trade. Using our risk per trade of $200 this would have determined a position size of 6,666 shares ($200/0.03) and the trade would have resulted in a win.

Risk management tactics in Real Time

It is easy to detemine a trade setup in hindsight, after the price action has played out.  However, to be successful in trading, you need to predict the most likely future price action based on your analysis and use this to determine your entry point and stop loss point.

After the previous momentum setups, the market entered the contraction phase and turned into a long-term consolidation. Every subsequent high got lower, while the buyers were ready to step in around 0.18 – 0.185, thus forming a descending triangle.

Price chart

In the upcoming price action, we’re considering going long. If the price goes below the 0.185 level, we’ll be proven wrong and have to close the position as we set the stop-loss below this level.It is not our preferred option to jump into the trade right after the price breaks the upper trend line on the descending triangle as this is not a high probability setup. The market is still in a transitionary stage from contraction to expansion and the EMA has only slightly ticked higher.  Also, in the case of such an entry, the Stop-loss must be somewhere around 0.18, which is a significant risk level.  If trading with a wide Stop-loss, the challenge is to catch a big enough move to justify the risk.

Instead, we want to see the market make an initial impulse move up, pullback and then break out above the local high, setting the Stop-loss below the low of the pullback. Additionally, the entry would be above the EMA to further support our trade analysis and confirm the upward momentum. The blue arrow shows the price action we would expect after a breakout from the consolidation and our preferred entry and the stop-loss points. By waiting for such a price structure, you can get a higher probability of a successful trade and a good risk-to-reward ratio.

Conclusion

You should set an overall risk management strategy that provides you with a limit of the amount you are willing to risk on any given trade.  This amount should be referenced to your total trading account.  A risk per trade equivalent to 1% or 2% of your trading capital is a safe level to protect your trading account over the long term. Then make sure that your stop-loss point is set based on your price analysis and is in the price area where you’re trade is proven wrong. The risk level (entry price less stop loss price) will determine your optimal position size for your trade.

Risk per trade $ / (entry price –  stop loss price) = position size

When you’re in the right entry zone, you don’t want to be stopped-out just because your stop-loss is in the wrong spot.