How we decide our position size?
I can rephrase the question as:
How we decide our stop loss and Target levels?
It seems confusing as to how position sizing and SL levels are one and the same thing, but I now know that indeed they are.
Here is how our ideas got evolved over time:
What generally happens with most of the crowd?
People generally follow the causality in following manner. First they will consider any random arbitrary ratio as their RR. The number is ususlly completely random and people consider it as their prerogative. They watch few/many videos on youtube, read some blogs, books etc. They are mostly told the same thing -
RR ratio < 1 is good. So you keep RR of 1:2 or 1:1.5 etc, whatever you like.
Nobody means nobody tells HOW to arrive at any specific ratio. Many youtube traders will just put in a sentence like "
Mai usually 1:2 ka RR ratio Raktha Hoon."
Why? Nobody tells, Nobody knows.
So what happens generally is that, most of the novice traders decide on the RR ratios before anything else.
So here is sequence of decisions that lead a trader to disaster.
1. Decide RR Ratio - 1:2.
2. See your Capital - 1 lakh.
3. Visit Margin calc. and see the BO/CO leverage - 20x (WoW!!)
4. Now calculate how much can I buy with my 1 lakh - Considering Scrip LTP of ₹ 200 - 10,000 shares
Okey, So I am gonna buy 10k shares!!!!
5. But I cannot loose more than 5000 here.
6. So My SL be 5k/10k = 0.5
This is the sure shot recipe of disaster. Your SL is going to get hit each and every time.
Now, What have I learned in the last year:
1. It is the chart or the Market which decides the levels, not you or any trader.
2. And hence, as a corollary, Your RR ratio is also decided by the chart and not you.
If you think you can keep any RR ratio and any SL that you like. then YOU ARE A FOOL.
Let me explain this a bit -
Suppose you are trading a certain counter and on the charts there are two things that you clearly notice that there is a Strong Support below LTP and strong Resistance above LTP.
Now consider that the Support is 2 Rs. below LTP and Resistance is 1 Rs above LTP. Now how will you keep your SL and Tgt levels? What will be your RR ratio? Clearly, If you have already decided to keep RR of 1:2, then either of the following two things will happen.
1. You keep SL at ₹ 0.5 below LTP as your Tgt is just ₹1 above LTP. Its nearly 100% sure that SL is gonna hit as it is between the Volatility of the price.
2. You keep SL at ₹2 below LTP, where there is a strong chart defined Support. Less chance that your SL will hit. But you are now forced to keep target of ₹4. This Tgt is hard to achieve as its way above strong market defined Resistance placed at ₹ 1 above LTP. So high chance that price will reverse sharply from the resistance and your SL hit within single candle!!!!!!
Thus both scenarios are Disasters.
So what shall be the proper levels and RR ratio?
In the above scenario, market told us that your levels are specifically these, hence your RR MUST be
2:1. Yes. For every 1 Rs gain you must be prepared to risk Rs. 2. At this point many veteran Market pundits will start criticizing me. But facts are fact.
Either don't take trade if RR defined by chart is skewed against you, OR continue reading below.
Now, if everything is in Markets' hand. And loss seems to be eternal truth. What's in trader's hand?
Position Sizing - this is what is in your's hands.
Position size is inversely proportional to RR ratio.
So if RR >1, its bad, reduce size.
if RR <1, Good, Normal size.
So the causality must be like following.
1. First, define levels as chart tells you. Calculate RR ratio accordingly.
2. Now decide how many cash you are prepared to lose in a day.
If for a ₹ 200 scrip, I am prepare to risk 6000, and chart defined SL level in 2 Rs below LTP, then you can buy at most 3000 shares.
To further risk management, decide how many trades that you will take in a day. If you decide on 3 trades, then position size reduces to 1000 shares per trade.
So, if I have 1 lakh margin, and scrip is trading at 200 apiece, and leverage in 20x, and therefore I can buy 10000 shares.
Still keeping the market defined SL of ₹2, my appetite of max loss of 6k per day, and max 3 trades per scrip, I must trade only 1000 shares.
Thanks.