Comprehensive Guide to Position Size and Leverage

Nota bene:

This is not financial advice and I am not a financial advisor. I’m sure there’re plenty of licenced professionals in your jurisdiction. Speak to them, not strangers on the internet with Hyman Minsky avatars.

These are just my loosely-held, shittily-formed opinions.

Leveraged trading can exacerbate your losses.

Image courtesy of icompareloan.com

Nearly every day, whether on Twitter, Telegram, or Discord, I see traders struggling to understand how to calculate their position sizes and generally make sense of leveraged trading.

It can be confusing at first.

In this article, I’ll break the concepts down to first principles and give you a very simple way to calculate position size, as well as understand how and when to employ leverage.

Also, so it’s clear from the outset: I use a market stop loss for every single trade, and this article carries that assumption throughout.

TERMS

Let’s define our terms.

Entry = price at which your order to buy/sell is executed

Capital = account balance

Position Size = number of contracts/units of an instrument you buy or sell e.g. BitMEX contracts

Stop Loss = order to close a losing position to prevent further losses

Risk Amount = Capital you lose on the trade if your stop loss gets triggered e.g. if I want to risk 3% of my Capital on a trade, my Risk Amount = Capital x 0.03

Leverage = borrowing Capital from your broker to open bigger positions than you would otherwise be able to

Liquidation = forcible closure of your position

POSITION SIZE AND RISK AMOUNT

Position Size and Risk Amount are NOT the same.

This is crucially important to understand, otherwise nothing else will make any sense.

If my Capital is $1,000 and I am risking 2% per trade, it means if my Stop Loss gets triggered, my losses will be limited to $20 ($1000 x 0.02 = $20). In other words, I will lose $20 if my Stop Loss is triggered.

It does NOT mean that my Position Size is $20.

POSITION SIZE CALCULATION ELEMENTS

In order to calculate your Position Size, you need to know your:

I) Risk Amount
II) Entry
III) Stop Loss

The simplest formula I use is as follows:

Position Size = Risk Amount/Distance to Stop Loss

POSITION SIZE CALCULATION EXAMPLE

I am trading XBT/USD perpetual swap on BitMEX, and I want to calculate my Position Size.

I want to short.

Capital: $1,000
Risk Amount: 3% (of $1,000) = $1000 x 0.03 = $30
Entry: 6568
Stop: 6797.2

Visualisation of the example

In order to calculate the Distance to Stop Loss part of the equation, I simply use the TradingView measuring tool, and then convert the percentage into a decimal.

To convert a percentage into decimal form, you simply divide the percentage by 100 (i.e. move the decimal point two figures to the left) e.g. 3.49% is 0.0349 when expressed as a decimal.

If your maths is truly horrendous, you can even use a percentage to decimal conversion tool.

Let’s return to our example.

Position Size = Risk Amount/Distance to Stop
Position Size = ($1000 x 0.03)/0.0349
Position Size = -860 contracts (I rounded up from 859.598854)

You can also backtest to see if your maths checks out.

860 (Position Size) x 0.0349 (Distance to Stop Loss) = 30 (Risk Amount) if price reaches my Stop Loss.

Checks out.

TIGHT STOP

The expression of having a “tight stop” should now make a lot more sense.

The closer your Stop Loss is to your entry, the bigger Position Size you can trade while keeping your Risk Amount the same.

It sounds counterinuitive, so let’s look at the numbers.

Suppose we have two traders, Tim and Wade, trading XBT/USD perpetual swap on BitMEX. They have the same Capital, Risk Amount, and Entry. The only difference is in their Stop Loss placement.

Visualisation of the example

Trader 1: Tight Stop Tim

Capital: $5,000

Risk Amount: 3% (of $5,000) = $5000 x 0.03 = $150

Entry: 6541.5

Stop Loss: 6518.3

Distance to Stop Loss: 0.35%

Position Size = Risk Amount/Distance to Stop Loss

Tim’s Position Size = 150/0.0035 = +42,857 contracts

Trader 2: Wide Stop Wade

Capital: $5,000

Risk: 3% (of $5,000) = $5000 x 0.03 = $150

Entry: 6541.5

Stop Loss: 6492.9

Distance to Stop Loss: 0.74%

Position Size = Risk Amount/Distance to Stop Loss

Wade’s Position Size = 150/0.0074 = +20,270 contracts

Thus, there is a balancing act. A tighter Stop Loss gives you bigger Position Size, but you also have less breathing room. A wider Stop Loss gives you smaller Position Size, but you have more breathing room.

Stop Loss placement should never be arbitrary.

If you want to know more about Stop Loss placement, I strongly recommend check out my article.

LEVERAGE I

If you’re going to take away one thing from this article, it should be that Leverage does NOT change the Position Size calculation.

Read that again.

Leverage does NOT change the Position Size calculation.

Instead, Leverage serves two primary purposes (among others):

  1. Reduces your counterparty risk by allowing you to trade larger Position Size without having all of your Capital with your broker
  2. Allows you to trade with a Position Size greater than your Capital when so required

Consider the following example of someone trading XBT/USD perpetual swap on BitMEX.

Capital: $10,000

Risk Amount: 4% (of $10,000) = $10,000 x 0.04 = $400

Entry: 6565.2

Stop Loss: 6519

Distance to Stop Loss: 0.70%

Visualisation of the example

Position Size = Risk Amount/Distance to Stop Loss

Position Size = 400/0.007 = 57,143 contracts

Wait, 57,143 contracts? But the trader’s Capital is only 10,000. How is that discrepancy reconciled?

Leverage.

Leverage allows the trader to open that position, which is greater than his Capital, using borrowed funds from the broker.

I reiterate: the fact that the Position Size in the example will be 57,143 contracts remains unaffected by Leverage. That number is fixed.

Opting for higher Leverage simply means that the trader wants to put up a smaller amount of Capital to open that same Position Size of 57,143.

Opting for lower Leverage simply means that the trader wants to put up a greater amount of Capital to open that same Position Size of 57,143.

So if you’re wondering what Leverage to choose, the answer is it really doesn’t matter as long as

Moving the Leverage slider will NOT change the number of contracts (your Position Size) — it will simply affect how much of your Capital you use to open that same position.

However, this does NOT mean you can use maximum Leverage simply because your Position Size is unaffected.

You need to ensure that your Stop Loss kicks in before your Liquidation. Using the Liquidation Price calculator, you can calculate your Liquidation before opening a position; thus allowing you to ensure that your Stop Loss comes first.

I cover this in more detail in LEVERAGE III.

LEVERAGE II

Leverage normally comes in two flavours: Isolated Margin and Cross Margin.

Isolated Margin

Liquidation liability is limited to the original margin posted i.e. broker will NOT use your remaining Capital to keep the position open.

You can also (overload permitting) increase/decrease your Leverage on the go.

This is usually the preferred method for traders taking one-off speculative directional trades.

Cross Margin

Broker can use all of your Capital to avoid Liquidation, but Liquidation means your total Capital goes to 0.

This is usually the preferred method for traders with multiple concurrent positions.

I don’t recommend using Cross Margin if you’re new to leveraged trading.

LEVERAGE III

Let’s put it all together.

How does Leverage affect the Position Size calculation?
The short answer is that it doesn’t, as long as your market Stop Loss is triggered before your Liquidation

The next logical question is “How do I know what my Liquidation price is before I have opened a position?”

The answer is that BitMEX (and most other exchanges and brokers) provides a calculator that does all the work for you.

BitMEX Liquidation Price calculator, found in the top left-hand corner of the website

It is imperative that you i) calculate your Liquidation Price before opening a position ii) ensure that your market Stop Loss kicks in before you get Liquidated.

(The only exception is the rare case where you’re trading massive size on Isolated Margin and Liquidation is a more ‘efficient’ Stop Loss, but that won’t apply to 99% of readers.)

Your Position Size is far more important than the Leverage you employ. That is why it’s pointless to ask what Leverage is “safe” or what Leverage some other trader is using, because you have no idea of their other risk-related parameters. That information is incomplete and therefore largely useless.

I reiterate: Leverage does NOT change your Position Size

If I am long 10,000 contracts at X2 Leverage that does NOT mean I am long 20,000 contracts.

The only way you can make more is by risking more i.e. larger Position Sizes being key, NOT ramping up the leverage.

The simplest way to put it: Position Size is the most important thing, and Leverage simply allows i) your Position Size to be greater than your Capital when so required ii) trade your usual size without keeping all of your Capital with your broker

CHECKLIST

Here’s how I apply all of this when entering a trade.

I will supply some fictitious answers so that the format makes sense.

Assume this is for a long position on XBT/USD perpetual swap on BitMEX.

  1. What is my Capital? $1,000.
  2. What % of my Capital do I want to risk? 3%.
  3. What, therefore, is my Risk Amount? $1,000 x 0.03 = $30
  4. What is my Entry? 6500
  5. What is my Stop Loss? 6400
  6. What is the distance to my Stop Loss from my Entry? 1.54%
  7. What is my Position Size? Position Size = Risk Amount/Distance to Stop = 30/0.0154 = +1,948 contracts
  8. Using the BitMEX Liquidation Price calculator, will my market Stop Loss trigger (some way) before my Liquidation? Answer must be yes.

CONCLUSION

Here are some points that are hopefully clear:

  1. Position Size is NOT the same as Risk Amount, but it is derived from your Risk
  2. You only neeed to know your Risk Amount, Entry, and Stop Loss to calculate your Position Size
  3. Position Size = Risk Amount/Distance to Stop Loss
  4. The closer your Stop Loss to your Entry, the bigger your Position Size (and the inverse is true also)
  5. Leverage does NOT affect your Position Size and Leverage does NOT alter the Position Size calculation equation — the only way to make more money is by trading bigger Position Sizes (and the added risk that comes with doing so), not by moving a Leverage slider
  6. Use the Liquidation Price calculator prior to opening a position to ensure that your Stop Loss kicks in before you get Liquidated
  7. Asking/caring about what Leverage other traders use is pointless without knowing more information — it’s mostly used as a marketing gimmick

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