Risk Management and Position Sizing

How much to risk on a trade, how to size a position from the entry and the stop, why drawdowns are harder to recover than they look, and how leverage changes the maths.

Most trading education spends its time on entries. The part that decides whether you are still trading in five years is the part that comes after: how much you risk, where you admit you are wrong, and how large the position is.

Risk management is not a constraint on making money. It is the reason there is capital left to make money with. A strategy with a small edge and good sizing survives; a strategy with a large edge and poor sizing eventually meets the loss that ends it.

This lesson covers risk per trade, the position-sizing formula, stop placement, drawdown arithmetic, leverage, and the portfolio-level risks that individual trade sizing does not catch.

Risk is a number, not a feeling

“In risk” is not a state of mind. For a position, the risk is the amount you lose if the trade goes to your stop, and it can be calculated before you enter.

There are three quantities:

• Capital: the total you have allocated to trading.
• Risk per trade: the fraction of capital you are willing to lose on one idea, commonly between 0.5% and 2%.
• Stop distance: how far the price has to move against you before you accept the idea was wrong.

The position size follows from those three. It is not chosen first and then justified.

The position-sizing formula

For a long position:

Position size (shares) = (Capital × Risk %) / (Entry price − Stop price)

For a short position, the same with the stop above the entry.

The result is the number of shares that makes a stop-out cost exactly your chosen risk. The position’s total value is then size × entry price, and you check that you can afford it.

A worked example

Suppose:

• Capital: ₹5,00,000
• Risk per trade: 1%, so ₹5,000
• Entry: ₹100
• Stop: ₹95

Risk per share = 100 − 95 = ₹5.

Position size = 5,000 / 5 = 1,000 shares.

Position value = 1,000 × 100 = ₹1,00,000, which is 20% of capital.

If the stop is hit, the loss is 1,000 × 5 = ₹5,000, which is 1% of capital. If the stock rises to ₹110 and you exit, the gain is ₹10,000 before costs.

Now change one input. Move the stop to ₹90:

Position size = 5,000 / 10 = 500 shares. Position value = ₹50,000.

A wider stop means a smaller position for the same risk. This is the point of the formula: the stop distance and the position size are linked, and you cannot widen the stop without reducing the size unless you are willing to risk more.

A stop that is too tight

A stop placed at an arbitrary 1% below the entry is often inside the normal daily noise, so it is hit by randomness rather than by the idea being wrong. That produces a string of small losses that look like bad luck and are really a sizing problem.

The stop should sit at a level where the reason for the trade is invalidated: below a support level for a long, above a resistance level for a short, or at a distance based on recent volatility. A common volatility measure is the average true range (ATR), the average of the day’s range over a window. A stop at one or two ATRs from the entry gives the trade room to breathe, and the formula then reduces the size to keep the risk constant.

Drawdowns and the arithmetic of recovery

A drawdown is the fall from a peak in account value to the subsequent low. The percentage needed to recover is not the same as the percentage lost, and the gap grows quickly.

The formula is: recovery = loss / (1 − loss).

This is why a run of losses is more dangerous than it looks. Ten consecutive 1% losses reduce capital by about 9.6%, and the account needs about 10.6% to recover. The same ten losses at 5% each reduce capital by about 40%, and the account needs about 67% to recover. The strategy can be identical; the sizing decides the outcome.

A maximum drawdown rule is therefore part of the plan, not an afterthought: at a stated drawdown, reduce size, and at a larger one, stop and review. The rule exists because the person making the decision during a drawdown is not at their best.

Leverage and margin

Leverage lets you control a position larger than your capital. In futures and options, the margin required is a fraction of the contract value, so a small move in the underlying is a large move in your account.

Two consequences:

• The loss can exceed the capital committed to the margin. A futures position can lose more than the margin posted, and the broker will call for more.
• The stop may not be honoured. In a gap or a fast market, the price can jump past your stop, and the realised loss is larger than the planned one.

Leverage does not change the edge of a strategy. It multiplies the result, in both directions, and it shortens the time available to be wrong. A position that would be a 1% loss without leverage can be a 10% loss with it.

The sizing formula still applies, but the capital figure is the real capital, not the margin. If a futures contract’s stop-out would lose 10% of your account, the position is too large regardless of how small the margin looks.

Portfolio risk

Sizing each trade correctly does not make the portfolio safe. Five positions in five banks are, in a stress event, close to one position. The risks that sit above the trade level are:

• Correlation. Positions that move together add up. Check whether your ideas are genuinely different or the same idea expressed five ways.
• Concentration. A large position in one stock, sector or factor is a single bet, even if it was built from several trades.
• Event risk. Results, policy decisions, expiry and budget days can gap a position through its stop. Reduce size into known events if the plan says so.
• Liquidity. A position you cannot exit at a reasonable price is larger than it looks. Thin stocks and far options can trap a size that the formula said was fine.

A simple portfolio rule is to cap the total risk across open positions, not only the risk per trade. If each trade risks 1% and you hold ten correlated positions, the portfolio risk is not 10% divided by ten; it is closer to 10% in one direction.

The Kelly criterion, and why it is not a target

The Kelly criterion gives the bet size that maximises long-run growth given a known edge and payoff. It is mathematically elegant and practically dangerous, because it assumes you know the edge precisely. In markets you do not, and full Kelly produces drawdowns that most people cannot tolerate.

The practical version is fractional Kelly: size at a fraction of the theoretical optimum, often a quarter or less. That accepts slower growth in exchange for a drawdown you can survive. For most discretionary traders, a fixed risk per trade is simpler and more robust than an estimated Kelly fraction.

A risk plan in one page

1. Capital: the amount allocated, written down.
2. Risk per trade: a fixed percentage, for example 1%.
3. Maximum open risk: a cap across all positions.
4. Stop rule: where the stop goes and why, set before entry.
5. Maximum drawdown: the level at which size is reduced, and the level at which trading stops for review.
6. Leverage limit: the maximum margin used, as a percentage of capital.
7. Event rule: what happens to size before results, expiry and policy events.
8. Review: a periodic check of realised risk against planned risk, not only of profit.

The plan is only useful if it is written before the trade and followed during it. A rule remembered after a loss is a rationalisation.

Our lesson on technical analysis explains how to choose a stop level that means something. Trading psychology covers why the plan is hard to follow, and futures and options set out the specific margin mechanics of derivatives.