Basic Mathematical Approach for understanding Risk Management & Position Sizing

What are our Trading outcomes ?

• Break even
• Small loss 
• Large profit 
• Small profit 

Never :- LARGE LOSS 

You should Never Suffer a large loss 

• Because its harder to recover a loss than it is to make the loss 
• It takes a higher percentage win to recover a loss  

Lets see some basic Mathematics in detail to understand 

Example one 

Loss of 50 % and win of 50 % 

In the above example when the first trade we make its a loss of 50 % and in  second we have a win of 50 % - so if we are thinking that the account will be at break even - then we are wrong because we have have draw down of 25 percent (actually its little more than that cause i have not included brokerage in it )

Example two 
Now if you think that as we have made loss first so we have lost 25 % - then lets reverse it and see the result

Win of 50 % and Loss of 50%

Now in the above example even when the first trade we make is profit of 50 % and our account size grows to 15000 in the next trade we make a loss of 50 % on 15000 and our account reduces to 7500
result is the same - A draw down  of  25 % exactly the same result

Example Three 

The fact is that if you loose 50 percent of your capital -then your require 100 % profit to recover the looses and to right back where you started   - and its lot harder to make 100 % on your 50 % draw down account

Lets See Some Percentage Required to get the account size  to break even 

• Respect the Risk in the market 
• Make capital preservation your number one goal 
• learn with small accounts 
• In cooperate money management rules in your trading system according to your risk appetite  

Position  Sizing 

What is position sizing ?

Position sizing Specifically refers to how much should i risk on each trade -that means whether i should buy 5 lots of nifty or 10 lots of nifty -how should i determine - for this we should know three things 

• Our Account size 
• What % of our account size we are willing to risk ( it depends upon us some traders willing to risk 1 to 3 % - some risk 5 to 10 % it totally depend upon our Risk Tolerance ) but its better to start with small percentage (also by back testing your Stock or index over a period of 10- 15 years we will come to know the maximum draw down on that Script and accordingly we can fix the Risk  Percentage 
• Stop loss in rupees 

So the Formula for Position Sizing is 

Lets Understand  taking nifty as a Example 

Say for example our account size is 100000

Our % of Risk Tolerance is 2%

Our Stop loss is Rupee say 500 rupees  (10 points) 

So in the above case we can trade with 4 lots of nifty as 2 % risk for the trade