Yesterday, I came across an article by Harvey Walsh on Money Management rules for day traders. I was deeply impressed by it and thought that that was the piece of puzzle I missed in the game. Here is the link to the article.

Position sizing means that you first should determine how much money you can afford to lose for a single day, and how many trades do you plan to make each day. Assume every trade you entered is a loosing trade, then determine how much money you can afford to lose on a single trade. Then based on your profit/loss analysis, decide how many shares you should enter.

For example, let’s say that I have $5000 in my account and I plan to test this trading system using this amount of money. My maximum affordable loss is $5000. But I want to stay in the game for at least 5 months. Suppose I want to trade every day, 5 months is roughly 100 days.  And suppose I lose every single day, that gives me a maximum loss affordable at $50 per day.

If I wanted to trade in average of 2 stocks per day, and worst case scenario is I lose every single trade, then my maximum affordable loss per trade is $25. So if I spotted a stock and did my profit/loss analysis, I found that the potential gain for the stock is $1, whereas the potential loss if it failed to go my way is $.2, the profit/loss ratio is 5, which means it is a good stock for me to enter. But how many stocks should I hold? Well, that is when your maximum affordable loss per trade comes in handy. $25/$.2=125 shares. So your maximum size for this position is 125 share. And of course, the size of your position can vary vastly depending on the potential loss amount you determined for a particular stock, the stock price and your fund available, and how much leverage you have from your brokers.

Know your maximum affordable loss per trade is vital for keeping you in the game of day traing. It also gives you huge psychological advantage to stay in the trade without worrying about loosing big as you know in advance where your exit point is and exactly how much money you will lose.