Methods to calculate risk per trade

There are a number of available methods to calculate risk per trade. Detailed below are some common methods and their associated formulae. Risk management is one of the most understated elements of trading for all beginning to intermediate competence levels. Risk management keeps you from needing to reload your trading account. Despite being one of the most important pillars it gets relatively little coverage compared to other aspects such as trading strategies and indicators.

Deciding how much to risk per trade is critical. Establishing a methodology that works for you, considering your current experience level will support you to manage your capital to keep placing trades while you learn and improve. The more trades you take, provided you are noting and addressing your mistakes, the more you will improve. However, you need to survive the losing streaks and the mistakes.

Nobody wants to risk small amounts because the returns are smaller. This game is not about money at any stage. If you consistently risk the wrong amount relative to your capital, regardless of your capital size, you can and will go broke.

Fixed Dollar Amount

Formula:

Risk per Trade = Fixed Dollar Amount

In this approach, the trader decides on a fixed amount of money to risk on each trade, regardless of the trade's characteristics. For example, a trader might decide to risk $20 on each and every trade.

The advantages of this is that it is very simple and ideal for new traders who have one less calculation to perform before entering a trade. The only challenge under this approach is to decide how much that fixed dollar amount is. There is an element of common sense here, ie you should not risk $50 per trade if your account balance is $500 as your account could be blown if you have 10 losing trades in a row.

This method can be tweaked to consider other circumstances. For example, a set dollar amount for each time frame traded. A smaller amount of risk on the lower time frames could be set with increasing risk amounts as the time frame increases. This is a method I apply using the Percentage of Capital Method below. The rationale is that you want to have less risk on the smaller time frames. The lower time frames are difficult to trade and very intense. A string of losses as an aspiring trader can quickly destroy your capital if you are not careful.

The earlier you are in your trading career the lower amount you should risk. As you start to achieve some level of profitability you can assess whether you should increase the fixed dollar amount of risk per trade. New traders should consider trading as low as risk as possible, example $10.

Percentage of Capital

Formula:

Risk per Trade = Total Capital × Risk Percentage

This method involves risking a fixed percentage of the total trading capital on each trade. For instance, if a trader has $10,000 and decides to risk 2% per trade:

Risk per Trade = $10,000 × 0.02 = $200

This is by far the most popular method of calculating the amount of risk to take per trade. Suitable for both beginners and progressing traders. The calculation is straight forward and reduces the risk you take if you are on a losing streak, ensuring that you maintain capital to be able to continue to trade. If you are winning, the risk amount will gradually increase to reflect the fact that your account size is growing.

There is no surprise why this is a popular methodology. The percentage being set can reflect your risk appetite and your experience. For example, a new trader may want to start risking 0.5% of their capital in the early stages, gradually progressing to 1% or beyond. It would be aggressive to ever risk more than 1% of your capital per trade.

There are also many tweaks that can be considered, as discussed in the Fixed Dollar Amount method such as different percentages for different time frames.

Volatility Based Position Sizing

Formula:

Risk per Trade = Account Balance × Risk Percentage

Position Size = Risk per Trade / ATR × Value per Point

This method uses the Average True Range (ATR) to adjust the position size based on market volatility. The ATR measures market volatility over a specific period. The method is effectively using the percentage of capital method but is adjusting trade sizes to reflect market volatility.

When an asset is going through a period of high volatility, if you don't factor this into your trading then the risk of being stopped out is higher than it would be, should the asset be experiencing low volatility.

Kelly Criterion

Formula:

f = bp−q / b

Where:

• f is the fraction of the capital to bet or invest.

• b is the ratio of potential profit to potential loss.

• p is the probability of winning.

• q is the probability of losing (1 - p).

The Kelly Criterion is designed to maximise long-term growth by optimising the fraction of capital risked based on the probabilities and potential outcomes of a trade.

This is a very complicated method and requires the trader to have very detailed calculations of the types of trades they take from their strategy and what historic win rates are. This would mean they would need to keep very detailed results and statistics. An example would be as follows:

Assume a trader is analysing a potential trade for a particular strategy with the following characteristics:

• Account Balance: $50,000

• Probability of Winning (p): 60% (or 0.60)

• Probability of Losing (q): 40% (or 0.40)

• Profit to Loss Ratio (b): The potential profit per dollar risked is 1.5 to 1. This means for every dollar risked, the trader expects to gain $1.50 if the trade is successful.

This strategy deserves an article all by itself but if your crunch the example, f = 0.33 ie 33%. This would indicate a huge risk for that particular trade. This is the most advanced form of calculating risk and would only be considered in rare circumstances.

The gains would be enormous under this strategy but the drawdowns would be frightening and likely only be managed by individuals with an emotionless trained mind. An interesting approach that does have mathematical merits but one that is probably best to stay in the textbook.

Conclusion

There are no right or wrong answers for how much to risk per trade, it is an individual decision which is linked to many variables. The main objective is safeguarding capital to live another trading day. Be honest about where you are in your trading career. Ask yourself the following:

• are you already a profitable trader?

• what is your win / loss ratio?

• how much risk, relative to your account size makes you uncomfortable?

These questions are important because if you are not profitable your risk being taken should reflect that, eg taking 0.5% risk per trade compared to 1%. If you haven't built confidence in yourself, your strategy and trading ability, your risk per trade must be at a low enough level to tolerate the inevitable losses as you are learning. Don't allow your ego to stop you from reducing your risk per trade if your results are not supporting your current level of risk being taken in each trade.

Trade Clearly!