Position Sizing: The Art of Capital Allocation in Trading

Position Sizing: The Variable That Determines Success or Failure

Two traders use the identical system with the same entries and exits, yet produce completely different results. Trader A is profitable; Trader B blows their account. The only difference? Position sizing — how they determine the size of each position.

Position sizing is the bridge between your trading system and risk management. A system with a positive edge becomes useless if position sizing is too large (leading to ruin risk) or too small (failing to capitalize on the edge).

The Fixed Fractional Method

Fixed Fractional is the most popular method, stating: risk a fixed percentage of capital on each trade. This method automatically adjusts position size based on equity.

The Formula

Position Size = (Account × Risk%) / (Entry - Stop Loss)

Real example: $20,000 account, 1.5% risk = $300. Entry EUR/USD at 1.1000, SL at 1.0950 (50 pips). Each pip on 1 standard lot = $10.

Position Size = $300 / (50 × $10) = 0.6 lots

Advantages

• Automatically scales up when winning (compounding effect)
• Automatically scales down when losing (capital protection)
• Simple and easy to calculate
• Theoretically impossible to blow your account completely

Disadvantages

• Recovery from drawdowns is slower
• Not optimal for all situations

The Kelly Criterion: The Hedge Fund Formula

The Kelly Criterion was developed by John Kelly at Bell Labs in 1956, originally to optimize signal transmission. It was later applied to gambling and trading to find the optimal percentage of capital to wager.

The Kelly Formula

K% = W - [(1-W) / R]

Where: K = Kelly %, W = Win rate, R = Average Win / Average Loss (payoff ratio)

Example: Win rate 55%, average win $200, average loss $100 → R = 2

K% = 0.55 - [(1 - 0.55) / 2] = 0.55 - 0.225 = 0.325 = 32.5%

"Kelly tells you the optimal fraction of your bankroll to bet when you have an edge." — Edward O. Thorp

Fractional Kelly: Reducing Volatility

Full Kelly is very aggressive and creates high equity curve volatility. In practice, most professional traders use Half Kelly (50%) or Quarter Kelly (25%) to reduce drawdowns and psychological stress.

In the example above: Half Kelly = 16.25%, Quarter Kelly = 8.125%

Anti-Martingale vs Martingale

Martingale (NOT Recommended)

Double your position size after each loss to "recover" previous losses. While it sounds logical in theory, in practice it leads to Risk of Ruin = 100% when you hit a long losing streak (which will inevitably happen).

Anti-Martingale (Recommended)

Increase position size during winning streaks, decrease during losing streaks. The logic: "Let winners run, cut losers short" applied to money management. Fixed Fractional is a form of Anti-Martingale.

Volatility-Adjusted Position Sizing

Markets don't always have the same volatility. Use ATR (Average True Range) to adjust position size:

Volatility-adjusted Position = (Account × Risk%) / (ATR × Multiplier)

When ATR is high (volatile market), position size automatically decreases. When ATR is low (calm market), position size increases. This keeps actual risk more consistent than using a fixed pip stop loss.

Correlation and Total Portfolio Risk

Position sizing isn't just calculated for individual trades. If you have 3 long positions in EUR/USD, GBP/USD, and EUR/GBP, these pairs have high correlation. The actual portfolio risk is greater than the sum of individual position risks.

• Rule: Total exposure for correlated positions ≤ 3-5% of account
• When trading multiple pairs: Reduce each position size to keep total risk in check

Position Sizing for Different Strategy Types

• Scalping: Risk 0.25-0.5% per trade (many trades per day)
• Day Trading: Risk 0.5-1% per trade
• Swing Trading: Risk 1-2% per trade
• Position Trading: Risk 2-5% per trade (few trades, long holds)