Traders often ask how they can calculate their intended risk on capital. Stop loss is a great asset in minimizing one’s loss so that he or she won’t exceed their intended risk. However, another great feature of a stop loss is that it can help a trader set the size of their trade. Here are the basic steps on how to do that, with an example.
You must know how much money you have in your account. This might seem simple, but is still crucial. Let’s say you have $100,000 in your account.
How much are you willing to risk? In our example, let’s assume are willing to risk 1%. Based on the $100,000 in your account, this means you’re willing to risk $1000 on a given trade. The amount you’re willing to risk on any single trade should be something you chose before you start trading. It shouldn’t be different for each trade based on how promising you think the trade is.
Choose a market that you are willing to take a position in. For this example, we will use the Futures Oil market.
The futures market measures market movements in several units, including ticks. For this example, all you need to know is that 1 tick = 0.01 market movement = $10. If you’re interested it learning about ticks and other units to measure market movement, check out this article.
Once you see a market situation which you think would be a good opportunity for a trade, you must determine the stop loss, profit target, and entry point for the trade. There are different ways to determine these three price points, but if you’re looking for an overview on each, you can read one here.
The stop loss, profit target, and entry point should be based on the market, not a personal opinion. Learning how to set a stop loss and other price points is important, but for this example, let’s say we set a stop loss of 65.25 and an entry point of 65.50.
Based on the analysis from the previous step, you know that the difference between the entry price and the stop loss is 0.25, or 25 ticks. Each tick is $10, so the 25 tick difference equals $250 per contract.
Going back to the initial steps, you’re willing to risk $1000 on this trade. Now that you know each contract is $250, you know you can risk 4 contracts.
As opposed to leaving a you and your capital open to further losses, this method allows traders to control their risk under their own rules while keeping themselves within the market conditions.
Many times, traders don’t follow all these steps. This is a big mistake as it allows their capital risk to be wiped out much quicker. For example, if one were to decide that the stop loss point is 65.40, they can still take a position of 10 contracts totaling in $1000 (as a reminder: each contract contains 10 ticks which equals $100). This would not be wise, as their stop loss is too close to their entry point. This gives the potential for a small change in price to erase their position. This not only erases one’s account, but also prevents the trader from getting the opportunity to see if they were right and allowing the market to bounce back to where they predicted it to be. This is an important reminder that setting your entry point correctly is very important!
The steps to calculate position size based on stop loss are important to traders in the futures market. It’s crucial that you can properly set your stop loss, entry point, and target profit if you want to be successful. Being slow and diligent, and thinking carefully about a trade before getting any money involved is the best way to maximize profits.