Position sizing is the process of determining how many units of an asset to buy or sell based on your account size and risk tolerance. It is the single most important risk management technique in trading, ensuring that no single trade can cause catastrophic damage to your portfolio.
Position sizing works by calculating the number of units (lots, shares, or contracts) you should trade based on three key inputs: your total account balance, the percentage of your account you are willing to risk on a single trade (typically 1-2%), and the distance from your entry price to your stop loss. The formula is: Position Size = (Account Balance x Risk Percentage) / (Entry Price - Stop Loss Price). This ensures that if your stop loss is hit, you only lose the predetermined percentage of your account.
Suppose you have a $10,000 account and want to risk 2% per trade ($200). Your entry price is $50 and your stop loss is at $48, giving you a $2 risk per share. Your position size would be $200 / $2 = 100 shares. If the trade hits your stop loss, you lose exactly $200 (2% of your account), regardless of the stock price.
Without proper position sizing, traders expose themselves to the risk of ruin. A single oversized trade can wipe out weeks or months of profits. Position sizing ensures consistent risk across all trades, which is essential for long-term survival and profitability. Professional traders consider position sizing more important than entry signals.