This was originaly posted on Traderswin Stocks Trading. I have edited in this version. The advantage of using stop loss (mentally or submit to your broker) is nothing new. There are numerous literatures on this topic. To me, the most important feature of stop loss/trailing stop is giving me a peace of mind to ride the trend and protecting my capital and paper profit. I am not going to discuss stop loss now, instead, I am interested in position size with relevant to stop loss.
It is very important for a trader to believe and acknowledge that outcome of each trade is always unknown when we enter the trade. This leads us to a very important information, since the outcome of the trade is unknown, then "how much can I afford to lose in this trade?"
So we have an idea about the potential risk now, we should start thinking about position size. I remember I was once teased by my broker (partly because he is my friend) when I purchased only 5 lots of a penny stock. 'There is no way for you to make any big profit'. Well, outcome of this trade is not the purpose of this posting, but it does show that we tend to focus on the outcome of a trade instead putting the importance of protecting capital. It is not how much you are going to earn from the market, but how much you are preparing and afford to lose that matters. Remember, we do not know what is going to happen after we establish a position.
How much share to buy? A very simple formula is as below:
Position size = (Risk amount – commission)/(entry – stop loss)
This assumes we do have a trading plan with risk amount and stop loss well defined. Risk amount is defined as the amount we are preparing to lose if the trade did not work out. There are theories and discussion on determining risk amount, the most popular and the simplest one should be the 2% rule. The rule basically tells us "Never risk 2% of your total trading capital in any trade."
I use support/resistance level in conjunction with trend lines (Straight or sometimes parabolic) to determine stop loss level of any trade. This takes a little of time and experience to learn the technique.
The position size that is calculated by the formula will limit our risk exposure in the market. Of course, for punters or novice trader, no one shot big profit will ever happen since position size is limited, but, over the long haul, it shows us the way to survive in this fantastic business. Here are some good articles on Money management Position Sizing: Why Size Matters to All Investing Greats Money Management or Position Sizing or Bet Size… No Matter What You Call It, Better Know It