One of the biggest dangers of trading is blowing up your account. Traders only blow up for one reason: lack of risk management. A trader who wisely uses risk management techniques will trade for a lifetime, through the ups and downs of the markets and their trading system.
One of the keys to a good trading system which employs proper risk management is making sure you size each trade position correctly.
Buying too much can mean either too much trading (if you use close stop losses), or large losses on each trade. Buying too little means not taking proper advantage of each opportunity.
There are several easy methods you can use to calculate the proper size each position you enter.
In this post I will specifically talk about position sizing using the Average True Range ("ATR") of a security.
To get your position size, it is not necessary to understand exactly how the ATR indicator is calculated. But it is important to know what ATR does.
Average True Range is a calculation which, in effect, measures the dollar amount the security in question moves during the trading day, which is then averaged over a set number of trading days.
Average True Range is essentially a volatility measurement which changes from day to day.
Using ATR to size positions means the risk is based on recent volatility. A more volatile security will have a smaller position size while a less volatile security will have a larger position size. That is good risk management!
Steps to Calculate Your Position Size
These are the steps to identify all the components you need to complete a proper calculation of maximum position size using Average True Range.
- (R) Determine the maximum amount of equity you are willing to lose for each trade. This should be based on your total account equity at the time you enter the trade. (New traders should risk less than 1 percent per trade.)
- (P) Identify the current price of the security. I do most of my trade entries near the end of the trading day as volume tends to be higher. If you do your calculations after hours, use the closing price of the security.
- (V) Calculate the previous 20-day ATR. You do not need to calculate this manually. Just use a trading platform, your brokerage account trading window, or even Yahoo Finance. I choose 20 days because it is a sufficient time period (4 weeks) to get a good feel for recent market activity.
- (X) Determine your ATR multiple. Your ATR multiple will form the first stop loss on your position. A more patient, less active trader could use an ATR multiple which is 5 times the current 20-day ATR. A more active trader may choose an ATR multiple which is 3 times the current 20-day ATR.
The calculation for ATR-based maximum position size is as follows:
R/(V*X) = U (Total Number of Units)
U*P = Max Position
or, in a single calculation:
[R/(V*X)]*P = Max Position
This example will be a position size using the Average True Range method with GLD (SPDR Gold Trust).
- (R) This investor has a $100,000 investing account. His risk per trade is 1 percent. (The maximum amount of money he wants to lose if this trade goes against him is 1 percent of $100,000.) Therefore R = $1,000.
- (P) The closing price of this security is $113.44. Therefore P = $113.44.
- (V) The current 20-day Average True Range for GLD is $0.88. Therefore V = 0.88.
- (X) This investor is not highly active (not a day trader type), so his will use a multiple of 5 times the 20-day ATR. Therefore X = 5.
R/(V*X) = U
Calculation for U: 1000/(0.88*5) = 227.27 units
U = 227
Calculation for Max Position: 227*$113.44 = $25,750.88
The maximum position size of GLD for this trader purchasing today will be $25,750.88, or 227 units of GLD.
Based on the calculation, the trader will enter a purchase order to buy 227 units at a limit price of $113.44 per unit. On this trade, he will allocate 25.75 percent of his account equity to GLD.
The trader might choose to round this purchase down to 200 units if he wants to buy in round lots, thereby adjusting his risk down by a further 12 percent.
The initial stop loss price will be $109.04 (calculated as P-(V*X)). If the price of GLD falls to less than $109.04 near the close of the trading day, he will sell the position.
Alternatively, the trader can set a Stop Limit Order and have the trade automatically executed if the price falls to this level.
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