Position Sizing is an essential technique used to reduce risk when trading any investment, including cryptocurrency. Position sizing refers to how much of a position to take in an asset. It is a crucial factor that determines whether you end up liquidating your account or making a fortune. Even the smartest trading strategy in the universe won’t compensate for a trade size that is too big or too small. This article covers how to use position sizing.
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Most new and inexperienced traders will blindly throw in a random amount of money into an asset, then expect insanely high returns while ignoring the potential risks.
The volatility of the asset you’re trading is a significant factor in position sizing. Volatility simply refers to the amount of uncertainty or risk about the size of changes in an asset’s price. A higher volatility means that prices will vary over a more extensive range of values.
Theare a perfect example of something with extreme volatility. We’ve had huge upswings and massive corrections, many of which have resulted in extreme losses for some traders who can’t deal with these rapid fluctuations.
How to Determine Position Size
Let’s take a quick look at how position sizing should be determined. The first thing to consider when selecting your position size is preserving capital and avoiding any catastrophic losses. Catastrophic losses are those total losses that we will never recover from. This objective takes priority as we must never risk ruining our trading account.
If we want to simply preserve our capital, the optimal solution is not to trade at all but rather accumulate quality assets at discounted prices and hold for the long run.
If we trade a size too big, we risk losing all our cash. However, if we trade a size that is too small, we limit our potential profits. Ideally, we want to find a sweet spot that maximizes profits while protecting our trading capital.
Fixed Percentage Sizing Model
The Fixed Percentage Position Sizing Model is very popular because it is fairly simple to understand and easy to put in place. This model is also beginner-friendly since you don’t need a track record of trading to use it.
Essentially, this sizing model increases your position sizes as your account continues to grow. As we become better and more skilled traders, your trading account will increase in size as well as your position size. A rule of thumb for this model is not to risk more than 2-3% of your account in a single trade.
Example of Fixed Percentage Sizing Model
Let’s say you are willing to risk a $100 loss per crypto contract based on your stop-loss. In this example, you have $50,000 in your trading account. You want to limit your risk per trade to 2% of your trading capital.
Risk Per Trade = Fixed Percentage x Trading Capital
Risk Per Trade = 2% x $50,000
Risk Per Trade = $1,000
After you calculate risk per trade, you can calculate the number of contracts you can afford to trade.
Position Size (Number of Contracts) = Risk Per Trade / Risk Per Contract
Position Size = $1,000 / $100 = 10
A position size of 10 means you would only risk trading 10 contracts using this model.
Maximum Draw-Down Position Sizing Model
When you look at the equity curve of your trading account, you will notice peaks (highs) and valleys (lows). The difference between each peak and valley is what we call a “draw-down.”
The maximum draw-down position sizing model uses your maximum draw-down to tell how much you should be willing to risk.
The basic idea goes like this. Let’s pretend your largest draw-down per contract is $2,000, which means you can trade one coin for every $2,000 in your trading account.
The formula for cryptocurrency is this:
Position Size (Number of Contracts) = Trading Capital / Maximum Draw-down Per Contract
The critical input in this approach is the maximum draw-down per contract. However, the most significant draw-down per contract might be underestimated based on your trading records.
This is why we need to adjust the maximum draw-down number. To do this, we can simply use a multiplier. Keep in mind that a large multiplier will imply a more conservative approach.
For example, consider the maximum draw-down per contract of $1,000 and use a multiplier of 2. In this case, we can trade one contract for every $2,000 (2 x $1,000) in our trading account. The multiplier of 2 has halved our position size.
The maximum draw-down position sizing model is great because it limits our risk by giving a reliable, maximum draw-down input.
Average Down Strategy (Dollar-Cost Averaging)
Many professional investors have used the average down strategy, including Warren Buffet. Investors favor this strategy with a long-term investment vision in value-oriented assets.
This Position Sizing strategy is also known as “Dollar Cost Averaging” (DCA) and involves buying more coins when prices are red. This lowers the average buy-in price.
For example, let’s say you buy 100 coins at $50, for a total of
$5,000. Then the coin drops to $40. You then buy another 100 coins at $40, for a total of $4,000. You now own 200 coins and spent a total of $9,000.
The average price per coin that you own is now $45. If the coin rebounds to $60, averaging down would have been an effective strategy for seeing returns on your investment. However, if the coin continues to fall in price, you may lose money.
Why Traders Must Focus on Position Sizing
Position sizing is an important concept to understand for both day traders and long-term investors. By understanding the drawbacks of opening positions too large or too small and applying a system that works efficiently, you will significantly reduce the risks with trading.
There is a quote that says, “cut your losses short and let your winners ride.” However, be warned that many traders make critical mistakes here. Some traders will hold onto losing trades and think that they will be a “long-term investment.” Others may sell their winners too quickly, which prevents them from making even more significant gains in the future. Even WORSE is when some continue to buy in on losing trades thinking that they are effectively dollar-cost averaging into the trade. This is the quickest way to lose all your money.