Position size and leverage. Manual calculation and application

Cryptocurrency analyst, who calls himself CryptoCred and behind the photograph of an American economist of the first half of the twentieth century of Hyman Minsky, talks about trading with leverage, that is, the use of leverage, warning that it is not intended to be a financial consultant. The original material published on Medium.

To start note: trading with leverage can exacerbate your losses.

Almost daily I see at Twitter or Telegram or the shell traders struggling to understand how to calculate the size of the position, and understand to trade with leverage.

It’s easy to get confused.

In this article I debunk to the base of the existing concepts and give you an easy way to help to calculate position sizing and learn how and when to use leverage.

For every trade I use stop loss, taking into account what written article.

Terminology

Let’s define the terms.

The price of entrance / entrance (entry) is a price at which your order executes to buy/sell.

Capital (capital) is the balance on the account.

Position size (position size) — the number of units you buy or sell.

Stop— loss (stop— loss) — the request to close position to prevent further losses.

Risk amount (risk amount) — the capital you lose if your stop loss is executed. For example, if I want to risk 3% of my trading capital, my risk amount = equity x 0,03.

Leverage / leverage (leverage) is the use of borrowed brokerage capital for the implementation of margin trading in large positions.

Liquidation/closure (liquidation) — forced closing of your positions.

Position size and risk amount

Position size and amount at risk are not one and the same. It is fundamentally important to understand, otherwise the rest will not make sense.

If my capital is $1000 and the risk of the transaction is 2%, that means if my stop loss is executed, then my losses will be limited to $20 ($1000 x 0,02 = $20). In other words, I lose $20.

This **does NOT** mean that my position size is $20.

Elements for calculation of position size

In order to calculate the position size you need to know the following parameters:

risk amount;

entry price;

a stop— loss.

The simplest formula that I use looks like this:

**position size = risk amount / distance to stop loss.**

Example of calculation of position size

For example, I have unlimited swap contract pair XBT/USD (bitcoin/USD) on BitMEX, and I want to calculate the size of their position. I’m going to short sell.

My capital: $1000

Risk amount: 3% ($1000) = $1000 x 0,03 = $30

Input: 6568

Stop: 6797,2

To calculate the distance to stop loss in the equation, I use the means of TradingView application, and then translate the percent into decimal form.

To go from percent to decimal form, simply divide the percentage by 100 (in other words, to move the separating character to the left two points), that is, of 3.49% will be 0,0349 in decimal form.

If you struggle with math, you can use special programs.

Let’s return to our example.

position size = risk amount / distance to stop loss

position size = ($1000 x 0,03) / 0,0349

position size = 860 units (I rounded the number 859,598854)

We can test your calculation in the following way.

860 (position size) x 0,0349 (distance to stop loss) = 30 (amount of risk) if the price reaches my stop loss.

The results were identical.

**Hard (short) stop— loss**

The expression “tight stop loss” should now purchase a lot more sense. The closer your stop loss to your entry, the bigger the position size that you can trade with the same amount of risk.

This may seem counterintuitive, but let’s look at the numbers.

Suppose two participants, Tim and Wade, traded a pair XBT/USD with a perpetual swap on BitMEX. They have the same capital, risk amount and the price of entry. The only difference is in the placement of stop— loss.

**Trader 1: Hard/short stop (Tim)**

Capital: $5000

Risk amount is 3% (from $5000) = $5000 x 0,03 = $150

Input: 6541,5

Stop loss: 6518,3

Distance to stop— loss: 0.35% of

Position size = risk amount / distance to stop loss

The size of the position Tim is equal to: 150/0,00,35 = 42,857 units.

**Trader 2: Wide stop (Wade)**

Capital: $5000

Risk amount is 3% (from $5000) = $5000 x 0,03 = $150

Input: 6541,5

Stop loss: 6492,9

Distance to stop— loss: 0,74%

Position size = risk amount / distance to stop loss

The size of the position Wade is equal to: 150/0,0074 = 20,270 units.

Thus, there is the following correlation. More stringent stop— loss will give you a larger position size, but less space to maneuver. A wide stop loss will give a smaller position size, but more space to maneuver.

Placing a stop— loss should be considered.

Leverage, part I

The main thing you need to understand that leverage **does NOT INFLUENCE** on the position size.

Read again. **The size of the shoulder does not affect the size of the position.**

Instead, leverage serves two main purposes (among others): 1. reduces your risk, allowing you to trade with a larger position size, placing your capital into the accounts of the broker; 2. allows you, if necessary, to trade with a larger position size than is your capital.

Consider the following example of a pair trade in XBT/USD with a perpetual swap on BitMEX.

Capital: $10 000

Amount of risk: 4% ($10 000) = $10 000 x 0,04 = $400

Entry price: 6565,2

Stop loss: 6519

Distance to stop— loss: 0.70 percent

Position size = risk amount / distance to stop loss. The position size is equal to: 400/0,007 = 57,143 units.

Wait, 57,143 units? But the trader’s capital is only 10 000. How can this be?

Let me remind you, leverage allows the trader to open positions, by size larger than its capital using borrowed funds from the broker.

I repeat: the fact that the position size in this example is equal to 57,143 units, not due to leverage. This is a fixed value.

Choice of high leverage means that a trader wants to use a lesser amount of capital to open the same position in 57,143 units.

If a trader chooses lower leverage, it just means that he wants to use more of their capital to open the same position (57,143 units).

Thus, the choice of leverage does not affect the size of your positions, it will show how much of your capital you are using to open the same position.

However, this does not mean that it is possible to choose maximum leverage, simply because the size of the position does not change.

You need to be sure that your stop loss is going to happen in front of your closure (liquidation). Using the means of calculating the closing price, you can calculate the closing level before opening your position, and this ensures that your stop loss occurs first.

In more detail I’ll talk about this in terms of “Leverage, part III.”

Leverage, part II

Leverage is usually of two types: isolated margin and cross-margin.

A lagged margin

Responsibility for closing of the position is limited to the original margin, that is, the broker will NOT use your remaining capital to maintain your position open.

You can also change (increase or decrease) you use leverage in the trading process. This is typically used by traders with one-time direct speculation.

Cross margin

Broker can use all your capital to avoid closure, but the closure means that your capital becomes equal to 0.

Typically, this method is preferred by traders who work with several parallel positions. I don’t suggest to use a cross-margin, if you are a beginner in trading with using leverage.

Leverage, part III

Let’s summarize. How leverage affects the size of the position?

Short answer: no, as long as your stop— loss happening prior to your closing.

It would be logical to ask the question: “how do I know its the closing to the opening position?”

The answer is: BitMEX (like most other exchanges and brokerage firms) provides a tool for the calculation, which does all the work for you.

It is extremely important that you can: a) calculate the closing to the opening position, and b) be sure that your stop— loss will happen until closing.

(The only exception is the rare case when large transactions are made with a non-slip margin and the closure of more “effective” than the stop loss. However, this is irrelevant to 99% of the readers of this article.)

Let me repeat: the leverage does not affect the size of the position.

If I’m in a long position of 10 000 units with a leverage of 1:2, it does NOT mean that I am in a long position of 20 000 units.

The only way you can get more, at the risk of stronger — if it is more your position size, not the shoulder.

Simply put, the size of the position — the most important indicator, and leverage simply allows you to: a) make the position size is greater than the capital, if required; b) to trade in the right amount, without giving all your capital to a broker.

Control questions

Here’s how I apply all of the above into practice.

You need to answer the following questions (here is a fictional example of a long position pair XBT/USD with a perpetual swap BitMEX):

What is my capital? $1000

What part of the capital am I willing to risk? 3%

What is the amount of risk? $1000 x 0,03 = $30

What is the price of entry? $6500

What is my stop loss? $6400

What is the distance from my stop loss to the entry price? 1,54%

What is my position size? Position size = risk amount / distance to stop = 30/0,0154 = 1,948 units

Use the calculator the closing price BitMEX and find out whether there will be my stop loss before closing. The answer should be positive.

Conclusion

Here are some points which I hope now it is clear.

The position size is NOT the same amount of risk, it depends on your bet.

To calculate position size, you only need to know the amount of risk, cost of entry and the amount of stop— loss.

Position size = risk amount / distance to stop loss.

The closer your stop loss to the entry price, the bigger your position size (the reverse is also true).

Leverage does NOT affect the size of the position, its value is not included in the calculation of the position size. The only way to earn more money in trading is to trade with a larger position size (which, of course, more risky), and without increasing leverage.

Use the calculator the closing price before opening a position in order to ensure that your stop— loss will happen before closing.

Don’t wonder what size of leverage used by other traders, it’s just a marketing trick that will not benefit you.