Your position size should be derived from the amount that you are planning to risk on each trade and your maximum potential loss. This section will explain how to calculate the appropriate position size when creating your trading system.As we outlined earlier, there are various methods for exiting your position.You can use a time stop, execute a stop‐loss, exit based on a certain technical indicator, exit based on a fundamental event, or simply hold an option position until expiration.
If you are using a time stop or exiting your trade based on a technical or a fundamental indicator, then you will not know the exact maximum amount that you stand to lose on a trade because your exit is going to be determined by either your interpretation of the market condition using a technical or fundamental indicator or it is going to be determined simply by time. With this approach, your loss is not capped.
This can happen on even a binary option trade if you are not holding until expiration.When faced with this situation, you have to make an estimate of what your maximum loss will be on a trade.If you back‐tested your system, this can actually be fairly simple. You can look at your back‐test report and assess your losses.
You can take the highest loss that the system had historically and multiply it by 1.5 to be on the safe side and use this value as your estimate for your maximum potential loss.If you are going to be trading binary options and are planning to exit your trades before expiration, you can simply take the maximum collateral of your trade and multiply it by .8 or .9 and use this as an estimate.
You can also demo trade the system for a period of time. Take the maximum loss that you achieve, multiply it by 1.5 or 2 to be on the safe side,and use that.The main idea here is that if you don’t have a hard dollar stop or are
not holding the position until expiration, you will have to spend some time estimating your maximum potential dollar loss per unit on your trade.You want to be fairly conservative with this estimation.
In other words,make the estimate larger than you expect it to be. Doing so will control those negative emotions of greed and fear and, most important, justification.Your greed will be telling you to get into bigger trades so that you can “get rich quicker” and you will justify this by assuming a smaller maximum loss so that you can allow yourself to get into larger positions.
Your rational side has to step up and assume a larger loss per unit here to mitigate those counterproductive emotions.If you know the exact maximum that you stand to risk on a trade per unit of the instrument that you are trading, you can use the 2 percent rule to calculate the appropriate position size.
The great aspect of binary options is that you always know this maximum if you hold the position until expiration,which makes it fairly easy to determine the number of contracts that you should risk on a position.Let’s address how you are going to determine position size when you either know or have estimated the single trade maximum potential loss per unit for your trading system.
Calculating the position size can be done with some basic math. In order to do this, you first must determine the maximum dollar loss that you are willing to take on your entire account on one single trade. This is done based on your predetermined maximum percent loss (the 2 percent rule).
For example, if you have a $10,000 account and the most that you can lose on a trade is 2 percent, then your maximum dollar loss on that account is $200 (2 percent of $10,000).Once you have the maximum dollar loss that you can take on your account figured out, you need to divide this number by the maximum singleunit dollar loss to determine the maximum number of shares/contracts that you can trade on any single position.