Position sizing refers to how much you initially bet or allocate to your trade as a proportion of your overall account. This actually is not a random number but should come from a couple of other pieces of information.
Essentially you want to achieve two goals from your position sizing:
- To stay in business long enough to find the right opportunities.
- To make as much money as possible when you win.
To solve the first problem the answer would be to bet very small so you can bet an infinite amount of times.
To solve the second problem the answer seems to be the opposite which is to bet big when you have a win.
So to do both, you need to know how often you win and how often you lose.
This is why instead of losing real money, the most common suggestions for beginners is to trade a paper account (imaginary money account).
If you have the discipline to do this, your goal should be to keep very accurate records of trades so you can analyse before going live.
I say ‘disciplined’ because without real money on the table many casual traders simply are not focused enough to compile these details. I couldn’t do it with focus. I just said I’ll pay more attention when the money is real. That was a very expensive lesson.
Once you know the number of winners compared to the number of losers you have the first building block of the fundamental equation.
The next step is to compile some statistics on the amount you are winning when you win and the amount you are losing when you lose, on average.
Now you can calculate whether you are profitable or is there something that you need to tweak to be successful.
The change in equity from your starting balance will tell you the same thing but the crucial point of this exercise is to understand where does your money come from and where are you losing money. (Questions you should be answering).
This aspect of trading is most like a traditional business – you are doing the accounting function which in a bank’s finance department would be the analysis of variance in the profit and loss of a trader’s book.