One of the hardest thing for new and losing traders to understand is that trading is not primarily about how to be right more often. Rather, it’s about about acknowledging that we never know what’s going to happen next, and that every time we enter a trade, the most important thing is to have a plan for when and where to cut a trade if it’s not working. (The other part is knowing how to let a trade run once it starts working, but most traders don’t get to the point of having the opportunity to work on mastering that part.) Once you accept that you have no control over what happens after you enter the trade — no matter how good the setup — you come to realize that one of the best tools you have to manage risk is position-sizing.
When I look to enter the market I grade the trade according to risk. I will use a scale of 1 to 10, in half-point increments, and that will determine how many contracts all put on at any given point. The first thing I’ll do is determine where my stop should be according to what I’m looking at. Whether my stop placement is right or wrong is irrelevant. I place my stops where I feel that is the limit of the amount of risk I am willing to take. I will not randomly place my stop at two points just because I’m willing to risk two points. Two points is usually the max I’m willing to risk but I will enter my trade when it’s in an area close enough to where my stop can’t put me beyond that two-point range. So if I missed the beginning of a move and I’m trying to get in to a trade after it’s already started from what I feel is the initial starting point of the move, then I will either trade with smaller shares if the real stop (i.e. point where according to my initial expectation I’m wrong) is further than two points away or I will dial in and look for a scalp trade with minimal risk (i.e. just a few ticks) and if I’m correct I can usually get a little bit of profit at one point and start to scale out of my position.
All of the things that I rely on when entering a trade play a part in how I rate the trade. For example, if the trade is near a very very strong zone and I have a few areas of confluence overlapping that zone I might rate that trade an 8 and take a full position and then rely on the market activity or price action to tell me whether I should get out of the trade or stay in the trade. For a lot of the setups that I look for, I expect a quick reaction and if I don’t get that reaction quickly than I will either close the trade (regardless of whether for profit or loss) or tighten my stop. Some people may place their initial stop at 1 point, 2 points or three points etc. but for me just to place a stop at any specific number just because that’s all I am willing to risk on this trade, does not make any sense to me. If I think the stop is three points away when the market is trading at a given price — and since the most I’m usually willing to risk is two points — then I either have to pass on the trade or cut my size down and accept a three-point stop.
There are many different ways to go about this but I try to keep everything very simple and very basic. The longer the day goes on the lower my odds are I feel for various reasons. One of them being mental fatigue and the other is that volume and often volatility decreases as the day wears on.
If you do the math two points a day, net, on the S&P e-mini is all that you need to earn a very good living. All a trader needs to do is find a way to get consistent in earning two points a day and then just add contracts. You will be taking the same trades, only with more size. Doing this effectively and responsibly, however, is all about proper position-sizing. If a trader starts out trading too large or with too many shares, then the fear of losing takes over. Trading is like any other sport or any other business or any other activity that requires practice in order to build self-confidence. Example, many people do not like to speak in front of a large audience. Even with time and practice, getting up to speak in front of a crowd still may produce nervousness, but it becomes manageable. As you begin to speak in front of larger audiences let’s say 500 people, speaking in front of 100 people becomes a cinch. Trading is much the same in that if you start trading 10 contracts you can feel the nervousness and the fear and the uncertainty as soon as a trade starts to go against you. So you have to work your way up to trading 10 contracts.