One of the most critical things to consider when trading Contracts for Difference [CFD’s], stocks and shares is the management of risk. Given that risk is magnified in proportion to the amount of leverage or deposit used, we need to tread very carefully.

First let’s look at a traditional trade of shares or stocks

Let’s say we identify an opportunity to buy company ZYX at $10 as it has satisfied the rules of our ‘trading system’, the stop loss for the trade is $9.50 if the trade does not turn out as expected – this equates to a risk of .50 cents per trade. This is step one.

Step ONE

Identify Buy price $10.00 Identify Stop Loss $09.50 Map Risk $00.50

The next thing we do is to work out our position size based on the AMOUNT OF RISK we are willing to accept.

If you have a trading system that you have historically tested to be accurate and you are VERY confident of it performing well into the future then you could consider using 10% of your account per trade. This means you would have in the worst case scenario 7 to 9 losing trades before all your money disappears.

Professional traders, fund managers and floor traders are well aware of the road kill left over after new traders come out with all guns blazing and and are crushed by the juggernaut of the real world of trading, meanwhile the professionals just keep plodding along…. risking their 1% to 2% of account and steadily building profits over time. If one to two percent sounds boring let me let you in on a little secret…. if you are trading for excitement you’re not going to last long! In my experience profits that come fast also go fast, until you get your mindset right about money.

Let’s assume we have $10,000 in our trading account, if you didn’t know any better you might think $10,000, great! Let’s buy $10,000 worth of stock – WRONG – this is GAMBLING which is significantly different to TRADING.

Using the previous example let’s say we are willing to lose a maximum of 10% of our trading capital – we could equate this to having $100 in your pocket in $10 dollar bills and losing one $10 bill. You wouldn’t mind so much I imagine, but if you had a single hundred dollar bill and lost that you’d be ‘feeling’ pretty annoyed wouldn’t you, so for the sake of sanity we’ll assume we are ‘OK’ with losing 10% of our trading capital.

POSITION SIZE

So, here’s the equation for working out how many shares to buy-

POSITION SIZE = RISK CAPITAL/ RISK

so our $1000 is divided by $0.50 to give us a figure of 2000.

2000 shares X $0.50 = $1000 which is our ‘agreed’ risk.

So we can purchase 2000 shares of Stock ZYX, but in this example we are limited by our account size – $10,000.

Were we to buy the full 2000 shares we would need to find $20,000 in capital…. this is where CFD’s or margin accounts are VERY useful.

IF we buy 2000 CFD’s of the stock ZYX we would only need to put down a deposit of 5% of the $20,000 stock value

(2000 X $0.50) X $10 / 5%

Deposit to HOLD $20,000 CFD’s of stock ZYX = $1000

Now we just need to sit with the trade to see if it turns out as we EXPECT or lose the ‘agreed’ amount.

Let’s say that our target – because any good ‘Trading system’ should have exit targets to sharpen the mind- let’s say an exit was signalled at $10.30 – we would make $0.30 on each share , so:

A profit of $0.30 per share on 2000 shares of ZYX = $600 profit. 2000 X $0.30 = $600

If the trade had not turned out as planned the equation would be as follows:

A loss of $0.50 per share on 2000 shares of ZYX = $1000 loss. 2000 X -$0.50 = -$1000

So there you have it let’s recap:

Step ONE

Identify Buy price $10.00 Identify Stop Loss $09.50 Map Risk $00.50

Step Two

Identify how much of your trading account you are willing to put at risk in our example a 10% risk on a $10,000 account = $1000

Step THREE

IDENTIFY POSITION SIZE = RISK CAPITAL/ Mapped RISK

So our $1000 [10% 0f $10,000] is divided by $0.50 [STEP ONE] to give us a figure of 2000 shares.

If you cannot trade CFD’s but have access to margin lending you can apply the same principles, though of course you would also need to be aware of the ‘leverage ratio’ as required by your lender.

You can download a free XL spreadsheet from my website which simplifies all these things – http://mymillionairebuddy.com/trade-register.html

Paul J Penton is a Private Trader and Wealth Educator Free Wealth creation Resources are available from his website http://mymillionairebuddy.com