When you enter a trade, you make two decisions: deciding whether to go long or short and determining the quantity to trade. The decision on quantity is always based on your account equity. Ralph Vince emphasises the importance of this decision in maximising returns while managing risk in his book “The Mathematics of Money Management: Risk Analysis Techniques for Traders.”
Multiple factors influence the decision on quantity, including the perceived “worst-case” loss, desired account growth speed, and reliance on past trades. Trading a fraction of the account on each trade is crucial as it leads to faster account growth. However, the quantity decision also takes other considerations beyond just the equity in the trading account.
The Basic Concept
A key concept in deciding on quantity is understanding probability statements. These statements are numbers between 0 and 1 that specify the likelihood of an outcome, with 0 indicating impossibility and 1 indicating certainty. In an independent trial process, like a coin toss, the probability remains constant from one event to the next; for instance, each fair coin toss has a consistent 50/50 chance regardless of prior outcomes. This concept is crucial to understand when considering the link between risk and quantity in trading.
Mathematical Approach
Deciding on the right trade quantity requires a mathematical approach that takes into account both the account equity and the potential worst-case loss. For instance, if an investor has a $50,000 account and anticipates losing $5,000 per contract in the worst-case scenario, it would be prudent for them to consider trading 5 contracts with a divisor of 0.5. This way, they can ensure that their risk aligns appropriately with their account size and possible loss.
The Impact of Incorrect Quantity
The consequences of incorrect quantity decision-making can be significant, potentially leading to missed potential gains and increased risk over time. It’s important to eliminate the misconception that trade direction dominates the importance of quantity decision-making. Regardless of whether the trade direction is correct or not, having the right quantity at risk is crucial for minimising the risks and maximising potential gains per unit at risk. This understanding can give you a sense of control and security over your investments.
Finally, proper position sizing is not just a critical aspect of investment management but also a powerful tool that can significantly enhance your trading strategy. By prioritising quantity decision-making and using a mathematical approach to determine the correct quantity for each trade, you can unlock the potential for improved account growth and long-term success in your investments. This approach can lead to substantial gains, giving you the confidence and motivation to continue improving your trading strategy.
Risk Warning: The information in this article is presented for general information and shall be treated as a marketing communication only. This analysis is not a recommendation to sell or buy any instrument. Investing in financial instruments involves a high degree of risk and may not be suitable for all investors. Trading in financial instruments can result in both an increase and a decrease in capital. Please refer to our Risk Disclosure available on our web site for further information.
