This is a continuation of my previous article here. I want to talk about the logical link between the risk we assume on an initial trade, the sizing of that trade and the expected reward. I already mentioned before that my preferred risk is no more than 0.5% of equity under management. Let’s see how that plays out with a practical example. For ease of calculation, I’ll consider we have an $100k account, 0.5% of which is $500.
Let’s say I want to short this pair as it breaks out of the rising wedge pattern. The technical target of the pattern in this particular situation is around 100 pips, giving us a rough idea of what can be expected. It can be more, or it can be less than that, but there’s no way of knowing at this point. What I do know is that I wouldn’t want to risk more than around 25-30 pips at the most. Consequently, the size of the position would be no bigger than 1,5 full lots, to allow for slippage.
There are 2 technical levels of stop-loss that I can use, depending on how much room I’m willing to give the price to wiggle before it proves without a doubt that the break-out is authentic. These levels are either above the consolidation at 1,3358 (conservative) or just above the wedge’s line at 1,3344 (aggressive), both marked on the second chart. Deducting the maximum accepted loss of 30 pips, it gives me 2 entry points: either 1,3328 in the conservative scenario or 1,3314 in the aggressive one.
We can see that the price spends very little time at the 1,3328 level, the optimal entry point for this trade, so most traders would have to contend themselves either with the aggressive scenario or with letting this one go by.
I hope this example helps explain that before considering any potential market involvement my first question is always ‘what potential loss can I suffer ?’. Only after answering that, I’ll go to the second question ‘what’s the profit that I can realize here ?’.