Risk is decided before the trade

Losses and gains are not symmetrical. A position that loses twenty per cent needs a gain of twenty-five per cent to return to where it started. A loss of fifty per cent needs a gain of one hundred per cent. The arithmetic is unforgiving and it is the reason experienced participants spend more time deciding how much they can lose than how much they might make.

Size follows the exit

The most common error in position sizing is to size from conviction. A trader who feels strongly about an idea takes a larger position. But conviction has no bearing on where the idea is wrong, and the distance to that point is what determines how much is at risk.

The sound order is the reverse. First decide the level at which the idea is invalid, the exit. Then decide the fraction of capital that may be lost if that level is reached. The position size is simply the second divided by the distance to the first. Two ideas with equal conviction but different exit distances get different sizes, and a wide stop produces a small position. This feels wrong to many people and is correct for all of them.

Limits above the trade

A single position is not the only unit of risk. Positions in related instruments move together; a portfolio of ten "independent" trades in one sector is one trade with ten names. Total exposure, exposure by theme and the loss that can be sustained in a single day all need limits, and the limits need to be set when nothing is happening, because they cannot be set well when something is.

A daily loss limit in particular is less about the money than about the decision-maker. After a run of losses, judgement degrades in ways the person affected cannot see. A rule that stops trading for the day at a predetermined loss removes the decision at exactly the moment it would be made badly.

Leverage is not an invitation

Instruments that offer leverage of twenty or thirty to one are advertising a capacity, not a recommendation. Leverage magnifies the cost of being wrong without changing the probability of it. A participant using a fraction of the available leverage is not being timid; they are keeping the arithmetic of recovery on their side.

The first objective

Trading has one first objective, which is to still be trading next year. Returns are a second objective and they are only available to participants who have met the first. Every rule above is in service of survival, and survival is decided before the trade, not during it.