Perhaps the most important question a trader will face is “How much risk do I assume on the next trade?” A fundamental driver of risk is position size, or the amount of a given security accumulated during the execution of a trade. Position size has several definitions, depending upon whether the financial instrument being traded is an equity, debt, derivative or currency product.
How Position Size Impacts Risk
In futures trading, position size refers to the quantity of contracts being bought or sold. As the number of contracts involved in a specific trade increases, so does the degree of financial leverage. Higher degrees of leverage boost margin requirements as well as the assumed risk of the entire transaction.
As an illustration of the relationship between position size and leverage, let’s say a trader likes the probability of an intraday rally in U.S. equities. In an attempt to capitalize upon a possible breakout, the following scenario unfolds:
Any trades are educational examples only. They do not include commissions and fees.
- Market entry: The trader buys 1 contract of the E-mini S&P 500 (ES) at a predetermined price
- Position Size: Long, 1 contract
- Margin requirements: Intraday, US$500
- Exposure: The assumed capital risk is US$12.50 per tick
Shortly after opening the position, a release of positive economic data interjects optimism into the market. As a result, the trader decides to increase position size:
- Market entry: The trader buys another contract of the E-mini S&P 500 (ES) at the initial, predetermined price
- Position Size: Long, 2 contracts
- Margin Requirements: Intraday, US$1000
- Exposure: The assumed capital risk is US$25.00 per tick
Because the position size grew from being long 1 ES to 2 ES, the margin requirements and capital exposure per tick effectively doubled. Although actively trading a larger number of contracts may produce greater returns, it also involves the assumption of much larger risks.
Calculating Optimal Position Size
Futures markets can exhibit chaotic behavior. If a trader fails to address trade management and leverage before entering the market, errors attributable to subjectivity are likely to occur.
Three elements of futures trading are crucial in quantifying an optimal position size:
- Account size: The amount of risk capital available to the trader is a critical determinant of position sizing. Brokerage-specified, instrument-specific margin requirements must be met in order to take an active position in the market. In the event that they are not, open positions are liquidated, and market entry is prohibited.
- Risk tolerance: Often referred to as the “pain threshold,” risk tolerance refers to the portion of the trading account available to be lost on an individual trade. Commonly accepted tolerance levels range from 1 percent to 3 percent of the trading account balance.
- Stop loss: A stop loss is the market price in which a trade’s failure is confirmed, and profit is no longer a foreseen outcome. Stop losses are developed using many different philosophies, but in futures trading, they are most commonly quantified by a predetermined number of ticks.
By calculating the portion of the trading account to be risked and how expensive the trade in question will be, you can derive your optimal position size:
Maximum Capital Risk ÷ Specific Trade Risk = Optimal Position Size
Use the following procedure to determine the optimal position size for a trade of WTI Crude Oil (valued at US$10 per tick), assuming a US$10,000 account, 3 percent risk tolerance, and 15-tick stop loss:
Any trades are educational examples only. They do not include commissions and fees.
- Calculate the maximum capital risk (account size × risk tolerance):
US$10,000 × 0.03 = US$300
- Calculate the specific trade’s risk (stop loss in ticks × tick value):
15 × US$10 per tick = US$150
- Derive the optimal position size (maximum capital ÷ trade risk):
US$300 ÷ US$150 = 2 contracts
According to these calculations, the proper position size for the crude oil trader is 2 contracts. Putting on a trade with more than 2 contracts is an excessive use of leverage. Likewise, a trade with fewer than 2 contracts means that the potential gains are insufficient.
Summary
Remember that position sizing is 100 percent controllable. Although the futures markets are often unstable in nature, the implementation of leverage need not be. Trading with appropriate levels of assumed risk is an integral part of avoiding catastrophic loss and achieving longevity within the marketplace.
FAQs
Proper Position Size
The investor now knows that they can risk $500 per trade and is risking $20 per share. To work out the correct position size from this information, the investor simply needs to divide the account risk, which is $500, by the trade risk, which is $20. This means 25 shares can be bought ($500 / $20).
What is the position sizing method? ›
What is position sizing in trading? The simplest definition of position sizing is setting the correct trade size to buy or sell a certain instrument or calculating the dollar amount that a trader is going to use to open a new trade. It sounds simple, but it can actually be quite complex.
What is the formula for futures position size? ›
The formula for calculating position size is as follows: Position Size = Risk Amount / Stop-Loss Level, where Risk Amount = Position Size * Risk Level, and Stop-Loss Level = |(Entry Price - Exit Price)| / Entry Price.
How do you set position size? ›
To achieve the correct position size, traders need to first determine their stop level and the percentage or dollar amount of their account that they're willing to risk on each trade. Once we have determined these, they can calculate their ideal position size.
How do you calculate position ratio? ›
The open position ratio is calculated as the percentage of open positions held for each of the major currency pairs on a given trading platform or exchange, relative to the total number of positions held for all the major pairs on that platform.
How much is 1 lot per pip? ›
A standard lot refers to 100,000 units of base currency and equates to $10 per pip movement. A mini lot is 10,000 units of base currency and equates to $1 per pip movement. A micro lot is 1,000 units of base currency and equates to $0.10 per pip movement.
What is the maximum position size? ›
The Maximum Position Size is the maximum position allowed (absolute value) at any given time. For example, if you have a Maximum Position Size of 5, you may be long 2 E-mini S&P and short 3 Crude Oil.
What is position sizing based on volatility? ›
Volatility Position Sizing is a position sizing technique that allows a strategy to adjust to changes in the volatility of the instrument on which it trades. This method of position sizing can be particularly useful in markets that have a good granularity, such as cryptocurrencies.
What is the formula for futures? ›
The formula for computing futures prices can be expressed as: Futures Prices = Spot Price * [1 + (RF * (X/365) - D)], where: The risk-free return rate, RF, signifies the rate one can earn throughout the year in a perfect market.
What is the minimum position size? ›
In the forex market, for example, the minimum position size is typically a micro lot, which is equal to 1,000 units of the base currency in a currency pair. The maximum position size tradexn can vary but it is usually set by the broker and it could be as large as several hundred lots, depending on the broker.
It is also referred to as the amount of money being traded in a given asset. Carefully analysing position sizing will provide means for investors to arrive at the number of units that they can purchase within the level of risk that they are ready to assume. This will help them earn maximum returns and at minimal risk.
What is Kelly Criterion optimal position sizing? ›
For example, if you have a 60% chance of winning a trade that pays 2:1, the Kelly criterion suggests that you should bet 20% of your capital on that trade. The Kelly criterion is a formula that guides the optimal fraction of capital to bet on a favorable outcome, considering the probability and payoff of an event.
How do you calculate position size in stocks? ›
How do you calculate position size? Position size is calculated by taking the monetary risk on the trade and dividing this by the risk per share. Your risk per share is the entry price of the trade minus the stop loss price.
What is the formula for position sizing in stock trading? ›
To arrive at the ideal position size for your trade, you have to divide your account risk (money that you risked on that particular trade), calculated in step 1, by your trade risk (cents at risk), calculated in step 2. The formula can be expressed as Ideal position size = Account risk / Trade Risk.
