Position Sizing Is More Important Than You Think

04/30/2013 9:00 am EST

Focus: FOREX

Marc Principato

Director, SMB Forex training Program

Veteran currency trader Marc Principato of SMB University Forex Training Program details how smart position sizing allows you to trade with the reward to risk ratio in your favor.

Too often I listen to inexperienced traders overreacting, exaggerating, and showing how over dependent they are on things like technical analysis. Too many engineers and people who think they can outsmart the market by trying to define everything it does with some over restrictive measure, indicator, or data series. Much of the time, the objective of this pursuit is to arrive at some kind of indicator that will almost guarantee profits, or get you into a trade that will be correct 90% of the time. On top of that, this magical invention will allow traders to use stops just barely greater than the spread. So you spend days, months, and years struggling to find this advantage. It must exist right? How do global investment banks trade and rarely have losses? Is it magic?

No. It’s all about how you perceive risk. Perception of risk is what separates the analyst doing his job in his comfortable little cubicle from 9 to 5 each day from the professional trader (the pros I hang out with actually are in the office from 7am to 6 pm).

From my experience, people generally don’t like to lose. Trading is a game that is all about facing losses on a regular basis. So what happens? Many inexperienced traders rely on things like technical analysis to help them avoid losses. The problem is, any and every form of analysis only provides a loose guide as to what the market may be better positioned to do, otherwise it is not relevant to the market process.

People want the market to be exact. We like exact things, we like to control our environment. The market process is the farthest thing from exact. The value of any market expressed in terms of price is a result of a countless number of participants acting on the market in varying degrees. The collective result is a price that reflects the majority of actions at the moment. This means there is a very high degree of randomness in short-term price action. In my opinion this also means any attempt to measure this in order to time trades on small time frames is a fruitless pursuit.

So as traders how can we get around the messiness of the market and still win in the long run? My answer is with smart position sizing. Smart position sizing acknowledges two important and often overlooked considerations: account size and the broader trend. By understanding your broader price action, you can better recognize emerging trade opportunities and know which way to begin building a position in the market. By respecting your account size, you will limit your maximum position size to some proportional constrain relative to your account size. This means if you have a 5k account, you should be building positions with micro lots. If you have dreams of doubling your 5k account in two months, you need to quit while you still have money in your account.

The market is an environment where risk is constant. As traders, we do not want to hide from risk, but instead face it head on in a well thought out manner. By minimizing your leverage, you can face market risk very easily. If you are wrong, you feel little pain and you don’t add to your position until conditions are more favorable. If you are right, wait for the next opportunity to add and you win over time on the larger position. This allows you to operate with reward to risk ratio in your favor.

Trading is less about tools and measurements and more about understanding the crowd mentality and how to gain an advantageous position that allows for adjustment as conditions change. By operating with a broader view and working with your account in such a way that you can minimize the pain of noisy price action, you can effectively face risk and learn the true intentions of the market much more effectively.

By Marc Principato, CMT, Director, SMB University Forex Training Program

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