Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Trade Smaller to Make More Money
08/13/2009 12:01 am EST
Experienced investors will frequently say that money and risk management are much more important than just about any other trading activities. Unfortunately, newer traders are usually unaware of the benefits of these concepts and the risks of ignoring them. This article will help you understand one of these concepts: Learning to trade smaller to make better returns.
If winning and losing trades were evenly distributed, trade size would not be as big of an issue. The problem is that winning and losing trades will often run in streaks. No trader knows how bad their worst streak will be until it happens, and large position sizes can hurt your account balance during these streaks.
For example, imagine that you start with an account of $10,000 and lose 20% on a very big trade. You now have $8,000 in your account. In your next trade you win 20% but that does not get you back to break even. Your account balance is now only $9,600. You would have had to make 25% in your next trade just to get back to break even.
The problem illustrated in the last paragraph compounds very quickly when you have a string of losers in a row. The larger your trade size, the bigger the hole becomes when you experience this run of losing trades. In my research, I compared the returns of a profitable system with different positions sizes. You can see the results below:
- 1% position size results in total return of 10.5%
- 2% position size results in total return of 8.26%
- 3% position size results in total return of 6%
Recent market statistics about retail traders show that the average forex account size in the US is $7,000 and the average account holder trades an average of one lot 20 times per month. That is a pretty big trade size. If this "average trader" was using a 100-pip stop loss, then they are risking 14% of their portfolio per trade.
If the average trader looks like this, it is little wonder that the burnout rate in the forex market is so high. Learning to reduce your trade size to be the "correct size" is not easy. The correct trade size is a little variable and depends on your trading style, tolerances, and expected returns.
However, one of the best things you can do now is to test whether you are currently using the "wrong" trade size. Take your trading history from your actual account and begin reducing the trade size on a spreadsheet. Assuming you have been consistent in your sizing, you should be able to easily tell whether you could have performed better with smaller trades.
Although it is attractive to take big risks for theoretically bigger returns, trading too big over a series of many trades will reduce your returns, both in percentage terms and absolute dollars. Take the time to rethink how large your trades are and whether you are just sacrificing performance.
By John Jagerson of LearningMarkets.com.
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