Risk management: how a position's size follows from the accepted loss

Many people interested in trading focus on the question "when to enter?". Another question is often asked: "how much can I lose if I am wrong?". This question changes the way a position is sized. This article presents the 3 basic notions: the risk/reward ratio, the position size calculated from an accepted loss, and the placement of a stop, fixed or based on the ATR. It is neither a recommendation nor a method to apply: this article describes the mechanics of a calculation.

The risk per trade

The risk of a trade is the loss you would suffer if the price reached the level at which you abandon the initial hypothesis (the stop). It is measured in euros and can be expressed as a percentage of capital. Each person sets their own according to their situation: there is no universal right percentage.

The risk/reward ratio

The risk/reward ratio compares the targeted gain with the accepted loss:

Ratio = (target − entry) ÷ (entry − stop), for a long position.

Fictitious example. Entry at €50, stop at €48, target at €56. The risk per share is €2, the targeted gain €6. The ratio is 6 ÷ 2 = 3 (sometimes written "1 to 3").

This ratio says nothing about the probability of reaching the target. It is combined with the hit rate to give the expectancy: see the reliability of chart patterns and the calculation of expectancy. A ratio of 3 with a success probability of 20% gives a negative expectancy; a ratio of 1 with a probability of 60% can be positive.

Calculating position size

Position size follows from the accepted risk and the distance to the stop:

Number of shares = maximum accepted loss ÷ risk per share

Fictitious example. Capital of €10,000. The person aims for a loss of about €100 if the stop is reached (excluding slippage and costs), that is 1% of capital in this example, a value chosen for simplicity of calculation and with no reference value. The risk per share is €2 (€50 − €48). Number of shares = 100 ÷ 2 = 50 shares, that is a position of €2,500 (25% of capital in this example).

Note 2 consequences: a stop further away reduces the number of shares, and the size of the position in euros is determined, in this method, by the accepted risk and not by an amount chosen in advance. The cap can also come from available capital: if 50 shares exceed what you wish to commit, the size is reduced.

Where to place the stop?

There is no "right" position for a stop. 2 approaches are common:

A fixed stop, placed below a level judged significant (a support, a recent low). It follows the logic of the chart: see support and resistance.
A volatility-based stop, for example a multiple of the ATR (average true range), which measures the average amplitude of moves over a given period (often 14 sessions), taking opening gaps into account. If a stock's ATR is €1 and you use 2 times the ATR, the stop is placed €2 below the entry: the more volatile the stock, the further the stop.

A stop that is too tight is hit by mere fluctuations; one that is too far increases the loss per share, and therefore reduces the possible size.

The limits of the method

Slippage. The stop is a trigger level, not a price guarantee: in the case of an opening gap, execution can take place well below. The actual loss can exceed the planned loss. See stock order types.
Costs reduce the gain and increase the loss.
Repeated decisions add up. Several correlated positions can lose at the same time: a portfolio's risk is not the sum of independent risks.
A good calculation does not guarantee a good result. It frames the loss per trade, it does not create a gain.

Key takeaways

The risk of a trade is the loss suffered if the stop is reached, set before entry.
Risk/reward ratio = (target − entry) ÷ (entry − stop); it says nothing about the probability of success.
Position size = accepted loss ÷ risk per share.
The stop can be fixed or ATR-based, with a risk of slippage.

In Earnnest, the risk calculator on a stock's page gives an indicative position size from the capital and risk entered, and the backtest lets you set an ATR multiple for the stop and a risk/reward ratio: these are calculation aids, not recommendations.

This article is for information and education only and does not constitute personalised investment advice. The figures in the examples are fictitious and illustrative. Trading involves a risk of capital loss. Past performance is not a reliable indicator of future performance.