A pair of aces
In Poker, when you're dealt a pair of Aces, you know that you have a better chance of winning than if you were dealt a pair of 8's. This is the kind of hand you lay a larger bet on, while hopefully getting your opponents to feed the pot. It's straightforward, right - you just calculate the probability and play the odds.
Why then, in trading, do many people ignore Position Sizing? They risk the same amount of capital on each trade, ignoring their odds of success or failure.
Here is a real-life example from a Chasing Returns trader, Robert (numbers are rounded to make it easier to follow).
Robert was a profitable trader, making approx $20,000 in one year. However, on his first trades of the day he was losing over $25,000! This meant he effectively made $45,000 on the remainder of his trades.
So what did Robert do?
1) take evasive action
To save trading capital, he SIZED DOWN and made his first trade of the day 10 times smaller.
This reduced his average loss from -$100 to -$10 per first trade, saving himself a projected $18,000 in losses over the year.
2) size up
Next, Robert decided to SIZE UP his second and third trades. He increased them by a conservative 25% of size, as he didn't want to move out of his comfort zone in terms of capital at risk.
His expectation was to increase his average P&L from $50 to $60.
...and what happened next was a surprise
The average on Robert's second trades actually went up to $85 per trade. As he no longer had the burden of a large loss from his first trade, this allowed him to trade at his best, with minimal emotional baggage from earlier losses.
The benefits of position sizing to you
Position Sizing alone can't make you win more often, or increase your Risk:Reward ratio, but it can have two immediate effects:
- PROTECTS your trading capital
- LIMITS your emotional impact of losses by making them small.
Good traders recognise sabotaging behaviour and take action.