How It Works?
Risk management covers a wide range of different things. One of them is the position size. Risk management and position sizing go hand in hand.
Like most novice traders, as a new trader I used to trade with the same size in every trade I made. This eventually results in risking too much of your total account in a wrong trade, and wiping out many previous winning trades.
As a trader we need to practice Money Management. we need to manage our money (our entire account/ total trading capital). Good money management means:
You only risk a fixed percentage (of your total account) in each trade.
Most professional traders only risk a maximum of 1.5% to 3% of their total capital.
Your risk (the money you could lose) per trade is determined by where you place your stop-loss. Let me explain with an example:
- Total account capital = $ 1,000
- Max. allowed risk amount per trade: 1.5% of capital = 0.015 * $ 1,000 = $ 15
- position size = 10 coins at $ 10 = $ 100
- Stop-loss level not lower than: ($ 100 – $ 15) ÷ 10 coins = $ 8.5
As you see, the position size, your total capital, and the SL level are all tightly connected. When you decrease the distance to the SL, then your allowed position size increases. So a tighter SL, gives you a bigger position size for the same risk amount.
All this is to ensure that you never exceed the maximum allowed risk over your total capital in a single trade.
As a pro trader, you:
- First determine the SL level based on TA
- Next determine your position size: how many coins you can afford to buy, based upon your total capital and the maximum allowed risk %
- Coin price on entry = $ 10
- TA Stop-loss level = $ 8
- Total account capital = $ 1,000
- Max. allowed risk amount per trade: 1.5% of total capital = 0.015 * $ 1,000 = $ 15
- What is the max. allowed position size?
$ 10 – $ 8 = $ 2 risk per coin
$ 15 ÷ $ 2 = 7.5 coins or $ 15 ÷ 0.2 (risk % in decimals) = $ 75
(if 7.5 coins hit SL, then the total loss is $ 15)
I use the following position-size formula:
Nr of coins = (max allowed % risk per trade x capital) ÷ (entry price – SL price)
Practice this a lot, for a pro trader this should be second nature.
You can practice this by using the following list when planning a trade:
- What is my total account capital? $1,000.
- What % of my account do I want to risk? 2%. ($1,000 x 0.02 = $20)
- What is my entry price? $10
- What is my stop-loss price? $8
- What is my position size? $20/$2 = 10 coins
Trading with Leverage
Margin and futures trading allows you to borrow money against your current capital, to trade cryptocurrency (contracts).
So you don’t use your capital to trade crypto directly, but indirectly. You use your capital to borrow even more money. So you can buy a bigger position with less money. This is why it is also called leveraged trading.
“Liquidation” happens when the losses on your position exceed the capital you used to borrow that position.
That’s why you lose that capital on liquidation. So when you use ALL of your capital to borrow money against, then you also lose all of your capital on liquidation.
Leveraged trading can increase your losses. If you want to make sense of leveraged trading, then your allowed position size is indispensable information. But leveraged trading doesn’t influence your position size at all though. In leveraged trading your position size is also based upon the stop-loss price. Not on your liquidation price!
The leverage you apply doesn’t influence your position size.
- For example, if you buy 1 Bitcoin at 10x leverage, that doesn’t mean that your position size has increased to 10 Bitcoins.
But some traders take such a position size, that when liquidation entirely wipes out their position, they never lose more than the max. allowed risk over their entire account. In such case the liquidation actually acts as a kind of stop loss. So in case they want to move the liquidation price (stoploss) further away, they need to add margin to their account.