Now that we have learned when to participate and when to avoid the market, we need to learn how much we should trade. How many shares, lots, or contracts we trade is a direct extension of our money management rules. If the reader needs a refresher on money management, please view the money management page once again.
In order to determine how much money to commit to any trading idea, we must first measure our "worst-case" stop. This worst-case stop is the point where no matter what, we will exit the trade. This stop is determined by the trading strategy which we are using. Some traders prefer to have a fixed money stop such as "if I lose $500 on this trade, I'm out!". There is comfort in this approach, but it would be better for a trader to allow the market to determine how much to risk on each trade.
Let's give an example of how much a trader should commit to a trade. For our first example, the trader has determined that they are willing to risk 2% on each trade. This means that should this trade go absolutely wrong and the trader is unable to make any profit, they will lose 2% of their capital. This 2% determines how many shares, lots, or contracts they should trade.
For example Trader Tom determines that his initial stop on a trading position will be $.30 away from where the price currently is. Or his stop loss will be 30 cents below his entry price. Assuming Trader Tom has a $100,000 account and he is willing to risk 2% of his account on a trade, he should invest $6,667 in this trade. How did we get this amount? This amount is determined by the dollar amount a trader is willing to lose divided by the market move which would cause that loss. Now the trader can just divide the $6,667 by the current price of a share of the stock to determine how many shares he should purchase.
Another example: Trader Tom has instead decided to trade foreign exchange and has determined that his max loss is 20 pips away, or in decimal form, .0020 away. Also, he is willing to risk 2% of his $100,000 account on this trade. Since his max dollar loss is $2,000 and his max stop is .0020 away, he should purchase $1,000,000 worth of the currency. This is found by taking $2,000 divided by .0020.
As can be seen, this method of lot sizing allows an individual to trade large sizes when the perceived risk is small and requires a trader to trade small sizes when risk is large. Naturally, this leads the trader to seek out the least risky investments and protect their money by only trading the highest probability opportunities.