Hello! Welcome back to our module on Risk Management and Portfolio Maintenance.
In our last lesson, we established the single most important rule for long-term survival in trading: the 1-2% risk rule. We focused on why this rule is critical for capital preservation and how it provides a psychological buffer against devastating losses. You learned that your primary job as a trader is not to make money, but to protect the capital you have.
Today, we transition from the "why" to the "how." Our goal is to master the practical calculation that brings the 1-2% rule to life on every trade. By the end of this lesson, you will be able to calculate the appropriate position size for a trade based on your account size and your chosen stop-loss level. This is the mechanical skill that enforces discipline and turns risk management from an abstract idea into a concrete action.
The Three Inputs for Your Calculation
Calculating your position size is a simple formula that relies on three key pieces of information. Two of these you decide before the trade, and the third is determined by your analysis of the stock chart.
- Account Size: The total equity in your trading account.
- Account Risk (%): The percentage of your account you're willing to lose on a single trade (we'll stick with 1% for our examples, as it's a great starting point for new traders).
- Trade Risk ($ per share): The difference between your planned entry price and your stop-loss price. Remember from last lesson, the stop-loss is placed at a logical price where your trade idea would be proven wrong, not just at a convenient spot.
Let's look at how these pieces fit together.
The Position Sizing Formula
The calculation itself is straightforward. First, you determine the maximum dollar amount you can lose. Then, you divide that amount by how much you stand to lose on each share if your stop-loss is hit.
The formula is:
Or, more simply:
To see a clear, step-by-step breakdown of this process, please read the following guide.
Position Sizing in Trading: How to Calculate & Examples
The article 'Position Sizing in Trading: How to Calculate & Examples' from Britannica Money provides an excellent, structured guide to this calculation.
Please read the section titled 'Step-by-step guide to calculating position size'. It breaks the process down into three simple steps: determining your risk per trade, calculating risk per share, and finally, computing the position size.
Seeing the Calculation in Action
Now that you've read the theory, let's watch a practical demonstration. The following video explains the concept and shows how the variables interact.
Stock Risk Management: How To Calculate Your Position Size
In his video 'Stock Risk Management: How To Calculate Your Position Size,' trader Rayner Teo walks through this exact calculation using a spreadsheet. This will help solidify the relationship between your stop-loss and the number of shares you can buy.
Watch from the beginning to 06:31. Pay close attention to two things: How he calculates the number of shares (03:52 - 05:33). How the number of shares you can buy changes when the stop-loss is moved further away or closer (05:33 - 06:31).
As the video highlights, there's an inverse relationship between your stop-loss distance and your position size:
- Wider Stop-Loss (more room for the stock to move against you) = Fewer Shares you can buy.
- Tighter Stop-Loss (less room for the stock to move against you) = More Shares you can buy.
This is because your total dollar risk (e.g., $100) must remain constant.
A Worked Example
Let's walk through one complete example together.
Scenario:
- Account Size: $25,000
- Account Risk: 1%
- Stock: You want to buy shares of a company, let's call it "SOL Corp".
- Entry Price: You plan to buy at $50.
- Stop-Loss Price: Based on your chart analysis, you identify that if the stock falls to $47.50, the setup is no longer valid. This is your stop-loss.
Calculation:
-
Determine Total $ Risk Per Trade:
- $25,000 (Account Size) × 0.01 (1% Risk) = $250
- This is the absolute maximum you can lose on this trade.
-
Determine $ Risk Per Share:
- $50.00 (Entry Price) - $47.50 (Stop-Loss Price) = $2.50
- For every share you own, you are risking $2.50.
-
Calculate Position Size:
- $250 (Total $ Risk) / $2.50 ($ Risk Per Share) = 100 shares
So, you would buy 100 shares of SOL Corp. If the trade fails and hits your stop-loss at $47.50, you will lose exactly $250, which is 1% of your capital.
This image provides a great visual summary of this flow:
Test your understanding!
You have a $15,000 trading account and you've decided to risk 1.5% on your next trade. You want to buy a stock at $82, and you've placed a logical stop-loss at $79.
How many shares can you buy?
Show answer
- Total $ Risk Per Trade: $15,000 × 0.015 = $225
- $ Risk Per Share: $82 - $79 = $3
- Position Size: $225 / $3 = 75 shares
Practical Application: Build Your Own Position Size Calculator
Since you'll be doing this for every trade, creating a simple tool to automate the calculation is a great way to ensure accuracy and speed. Given your practical, hands-on learning preference, let's build one right now. You can use Google Sheets (free) or Microsoft Excel.
Learn How to Make a Simple Calculator for Risk Management Strategy (1 Percent Risk Rule)
The video 'Learn How to Make a Simple Calculator for Risk Management Strategy' by Soheil PKO gives a perfect step-by-step guide. We will follow his instructions to build a calculator for our 'long' positions (trades where we buy a stock expecting it to go up).
Open a new Google Sheet or Excel file. Watch the video from 01:47 to 06:41 and follow along to build the calculator. You can pause the video as needed. He explains exactly what to type in each cell and what formulas to use. By the end, you'll have a personal tool that you can use for all your future trades.
Having your own calculator makes this crucial step in your trading plan efficient and repeatable, which is key to building good habits.
Conclusion
Mastering position sizing is not optional for a serious trader; it is the engine of risk management. It's the action that ensures a single bad trade—or even a string of bad trades—won't take you out of the game.
Key Takeaways:
- The Position Sizing Formula: Your position size is your total dollar risk divided by your per-share risk.
- It's a Three-Part Calculation: You need your account size, risk percentage, and the distance from your entry to your stop-loss.
- Inverse Relationship: A wider stop-loss means fewer shares, and a tighter stop-loss means more shares, all while keeping your total dollar risk constant.
- Automate for Efficiency: Building a simple spreadsheet calculator makes applying this rule quick and error-free for every trade.
A Look Ahead:
In this lesson, you mastered the calculation that determines your position size based on a stop-loss. In our next lesson, we will get even more practical. We will focus on how to set a stop-loss order to define and limit the maximum potential loss on a trade directly within a brokerage platform. This will close the loop, connecting your risk calculation to the actual trade execution.