If you’ve been reading my stuff for a while, you’ve probably heard me talk about the five essential parts of a well-rounded trading strategy.
They are: what to trade, when to enter a trade, when to exit a winning trade, when to exit a losing trade, and finally – the bit we’re interested in today – how much to trade.
How much to trade just means how much of your overall trading account you’ll be allocating against the trade.
Depending on the market you’re trading, you might measure it by the number of shares bought or the number of futures contract bought.
Or, when it comes to Forex spread betting, you might measure according to how much cash to stake against each pip of movement in the market.
Position sizing – the medieval way
The other night I was watching a program on TV about medieval building methods. You might have seen it too. It’s about a team of craftsmen in France building a medieval castle using authentic techniques from the time.
I find this kind of programme fascinating, by the way. I built some sandstone walls in my garden a few summers ago and had a whale of a time, thoroughly enjoyed it. I must have been a stonemason in a former life or something.
So anyway, it was explained how each medieval site had a head mason. And it was the width of the main man’s thumb that became the standard unit of measurement for that entire building site. This practice remained in place until a project was completed.
The measurement was even scratched into a stone block so if (heaven forbid) the top chap fell off some rickety castle scaffolding and plunged from the battlements, the other builders would still have the size of the head mason’s thumb to work with.
They called the measurement a ‘pouce’, which is French for ‘thumb’. It is also French for ‘inch’ – and that’s where we get the imperial measurement from. I never knew that before!
Anyway, back to trading…
A standard unit of risk via the ‘Frenchman’s Thumb’ method
So I used the ‘pouce’ example to explain to some newer traders the importance of standardising the size of risk on each Forex trade…
When the medieval site foreman ordered some clay floor tiles to be cut and fired he might specify them to be six ‘pouce’ square. He didn’t just say “make me a hundred floor tiles”. The tiles were cut and formed by different craftsmen so he’d get all sorts of odd shapes and sizes arriving on site if he did that!
No, the tile makers knew exactly what the size needed to be for every piece they turned out. And they were held accountable too. Each man had his own little mark that he made in the edge of the clay tile. Kind of a signature, so the boss knew who needed a talking to should the size of the tiles start getting a bit freehand.
And that’s exactly how you need to think about the size of your trades. You can’t just fire off 50 pip risk trades here, 20 pip risk trades there – and anything in between – all risking a level stake of £1 per pip and still expect to see smooth growth in your equity.
There’d be no standard unit of risk. Some trades are risking twice as much as others and everything is out of balance. Do this and your account is likely to topple given time.
So you need to come up with your own ‘pouce’. You need your own standard unit of risk to apply to each of your trades.
How much of your trading bank should you allocate against each trade?
Common trading wisdom suggests placing a maximum risk of 2% of your total trading bank against any one trade and I think that’s a good benchmark.
But there are always exceptions to the rule…
If you’re trading a particularly large account you might have a more conservative outlook. You might be willing to risk only 0.5% of your account per trade because of the economies of scale involved.
You can still make big money… each one of your trades might have a potential cash return of £1,000.00 so you might decide the 0.5% risk profile fits your trading goals perfectly.
One or two of those trades a week should keep the wolf from the door!
And it means even a string of losing trades will hardly scratch the surface of your overall account.
If you’re trading a small account on the other hand, you might decide to risk more on each trade in order to grow your account more quickly. Again, that might be the right thing to do when you look at things in terms of cash…
A 4% risk on your account might convert to £15.00 in cash – it may well be a sum you feel comfortable risking in order to enjoy that faster growth to your equity. And don’t forget, you can always scale things back to risk 2% on each trade as your cash account grows.
So the key here is to do a quick reality check whenever you’re planning a trading campaign. It’s easy to get tangled up thinking purely in terms of percentages but I think you need to add in a ‘real world’ cash factor too.
Next time you’re about to fire off a trade, take a good look down at that thumb gripping the side of your mouse. It’s your prompt to check you’ve measured up the trade before pulling the trigger. It’s your very own trader’s ‘pouce’!
Be Prepared: Market Moving Data Coming This Week (London Time)
Wednesday 30th November:
08:55 EUR German Unemployment Change
10:00 EUR Core Producer Index
12:30 EUR ECB Draghi Speaks
15:00 USD Pending Home Sales
15:30 USD Crude Oil Inventories
Thursday 1st December:
08:55 EUR German Manufacturing PMI
09:30 GBP Manufacturing PMI
15:00 USD ISM Manufacturing
Friday 2nd December:
09:30 GBP Construction PMI
13:30 USD Employment Numbers!!
Monday 5th December:
09:30 GBP Services PMI
15:00 USD ISM Non-manufacturing
Tuesday 6th December:
– no big reports
So keep an eye on the clock this Friday aftrernoon – US job numbers!
Trade safely and I’ll catch you again very soon.