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What Is Position Sizing in Trading & How Can It Reduce Risk?
Wondering if position sizing reduces trading risks? Read on to better understand what position sizing is and find out how it can reduce the risk of trading.
Updated January 10, 2024.
When opening a trade, be it in a commodity or stock, it is important to establish a position size. This refers to the number of units that the trader holds in the specific security.
By establishing the right position size, your risk factor is diminished because it could prevent significant losses in one trade and can impact your potential profits (when there is a strategy behind this position).
When coming up with the right position sizing, be sure to consider these three components:
- Account risk: This takes into account how much you are willing to lose on your investment.
- Trade risk: This is the gap between your purchase and stop loss, so if you purchase a security at $10 and your stop loss is $8.95, your trade risk is $1.05.
- Proper position size: The correct position size is generally based on two factors—the time and date of your stop and the dollar amount or percentage of your account that you are willing to risk on the trade.
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Position Sizing & Gap Risk
Unfortunately, like any other investment strategy, position sizing is not 100% foolproof. Even with the right calculations and best position sizing, there is still a risk of losing your money, whether because of a stock gapping below traders' stop-loss orders or the performance of the broader financial markets.
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