Wednesday, February 11, 2015

Profit erosion and position sizing

Just as fast as you make money in the markets, they can also take those profits away from you just as quickly, if not quicker. So far this week, there has been an erosion of open profits on some positions, resulting in stops being hit, with those trades ending up as small winners/small losers.

While it is frustrating, it has to be expected. What we don’t know is, when prices starts to move in the opposite direction, whether this is some whipsawing or noise, or maybe the start of a sustained price movement in the opposite direction. But, at the same time, you need to allow your trades some 'wiggle room' so you do not end up being stopped out on some minor price noise.

On that basis, having stops in place at all times, while only risking a small element of your equity on each trade, should help take the emotion out of your trading decisions.

What you want to avoid at all costs is to override your stops – it is sod’s law that, on the one occasion you override such a stop, and do not take a small loss, then that trade will develop into a major loss. All this does is blow a big hole in your trading capital, and cause damage to your trading mindset.

Because I cut any losing trades very aggressively, and accept that open profits can disappear, this is why my position sizing is based on cash equity only. I do not want to calculate my position size and risk per trade including profits which could literally disappear overnight (as we saw here).

By calculating position size in this manner, then my risk per trade is a bit more conservative than most traders, who would include open profits. Again, no one can say whether either way is right or wrong for everyone, but basing position size on cash equity only is the right way for me.

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