Let's play a game. Heads I win, tails you lose. Deal? Just kidding. Let's play a real game.
We will bet on coin tosses. I will flip the coin, and you get to call it in the air. Readyl? Let's get started. $5 a toss.
We begin our game and things are going smoothly for you. You win the first toss. An easy $5 for you. Shall we play again? What do you know? You win again. I'm way overdue for a win so I challenge you for another round. Would you believe it? Today is your lucky day and you have won again! Let's give it another spin. This time, things just have to go my way. I know I will win this round. I flip the coin high into the air and let it land on the floor. You call heads. The coin lands. Another heads!! I can't believe it. You won again. This is insane. We continue to play our game, and you win the next 5 tosses. Now, something has to be up! How can you do this? Feeling confident, you decide that you have mastered coin flipping. You are convinced you have some uncanny ability to sense which way the coin will land. Bold and assured, you ask for one more flip. But this time, you want to bet $500 on this one flip. I agree. I fling the coin high up in the air, "Heads," I hear you proclaim without a slight hint of nerves. Our coin lands to the floor. We hover over it. Tails! I won! You are in shock! Not only have you lost, but you have lost your entire winnings and then some. What happened?
Although you've become really good at predicting coin flips, you have yet to master the art of position sizing. What is position sizing? It is simply how much you risk on each flip of the coin. Let's take a closer look at what you did:
Toss 1: Bet $5
Toss 2: Bet $5
Toss 3: Bet $5
Toss 4: Bet $5
Toss 5: Bet $5
Toss 6: Bet $5
Toss 7: Bet $5
Toss 8: Bet $5
Toss 9: Bet $5 Toss 10: Bet $500
You were right nine out of ten times, but you lost money. Why did this happen? You varied your position size. Unfortunately for you, the one time you lost you placed a big bet. See, it's not just about accuracy. Position sizing did you in here. The same thing goes for trading. Successful trading is dependent on position sizing. There is no way around it. You must limit your losses to 1R or less on each trade. Make it a point to keep your risk in check on all your trades. Understand how many shares you need to own in order to never lose more than one percent of your total account value on any given trade. Keep this in mind the next time you trade in the stock market or bet on a simple game of coin toss.
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