Before you start trading, as an essential part of your risk management, you will need to determine your risk amount. This is the amount you are prepared to lose every time you open a position. Not you will lose … you are prepared to lose.
Your risk amount will form the basis of your position sizing. It is normally represented as a percentage of your trading capital, and ideally should be no more than 2 per cent.
What this means is that every time you open a position, you are prepared to lose 2 per cent of your trading capital and no more. Interestingly, as an aside, some of the professional traders that I have read about will say that 2 per cent is too much to risk and yet, many people will say that 2 per cent is not enough to risk!
Your position sizing will ensure that, regardless of how far your initial stop is away from your entry, you should never lose any more than your risk amount in any position. Remember, preserving your capital is the primary aim of trading and, if you do not manage risk, you will fail.
This is an important point. Your placement of your intial stop loss should determine how many shares you buy and not the other way around.
A further restriction you could enforce to manage your risk in the market is to ensure that you only have a certain percentage of capital at risk during any one time across all open positions.
For example, this figure may be 6 per cent. In this case, if you presently had three positions open (2 per cent risk in each), where the initial risk was still at risk (i.e. you had not moved your stops up to protect an unrealised profit), then you would not open a fourth position until one of the others was closed or moved into a profit.