Capital preservation is a key to long-term successful trading. Almost everyone has seen the numbers of how much percentage gain it takes to make up a loss. A 20% drawdown takes a 25% gain just to get back to breakeven. A 50% drawdown takes a 100% gain to get back to even. It takes a lot to make up a significant loss.

Too many traders swing for the fences with visions of big profits from big positions. That's a pipe dream. Big positions can result in big losses that are very difficult to recover. There will come a time when you think you've got the market wired. Every technical position from short- to long-term points to one thing: a major trend. You break every commonsense risk rule and commit your account to the position with a wide stop "to give it room." The market moves against you and you think it is a buying opportunity to add even more positions at a better price. You know the end of this story. The market doesn't stop moving against you and you either exit with a major loss or are taken out by the broker when you run out of capital for margin.

A major loss is very difficult to recover from, both emotionally and financially. Successful traders always have a relatively close stop. If stopped out for a loss, it is an acceptable loss. It is absolutely critical to minimize losses and preserve capital. It is that simple. Assume any trade you place could be a loser, and never risk more than a small amount of capital on any one trade or any group of open trades.

The best professional traders rarely have a greater than 50% win record. That's right. Long-term successful traders usually have more losers than winners. Most amateur traders simply don't accept this reality, which is why they are not ruthless about limiting the potential loss on any one trade. Listen up, reader. If you have better than a 50% winning trade percentage over time, you are among the trader elite. If you get good at trading, you will have around a 30 to 40% win percentage. That is why it is absolutely, positively, unquestionably critical that the losses on losing trades are relatively small and profits on winning trades are relatively large. There is no other way to trading success.

Up to this point in the book, you have learned to identify conditions for trade setups and objective entry strategies with a defined entry and initial protective stop price so you know exactly what the capital exposure is per trading unit before the trade is executed. Now it is time for you to learn what is the maximum capital exposure (risk) that is acceptable for any trade and all open trades.

I use the term capital exposure to define the dollar amount that may be lost on a losing trade. Most trading educators call this risk. Risk is the probability of an event happening and has nothing to do with a dollar amount. Risk is not a proper term for the dollars that may be lost. Capital exposure is a much better term. However, since risk has become a term associated with the amount of capital that could be lost, I'll occasionally use the term since it has become a convention.

Let's get down to brass tacks and learn what every successful trader puts into practice. The maximum capital exposure for any trade must be relatively small and the maximum capital exposure per trade unit will determine maximum position size.

There are many complicated methods to determine position size but the simplest is the best. When I first started trading in the mid-1980s, the teachings of W. D. Gann were my main guide. One of Gann's rules was to never risk more than 10% of your account capital on a position. That rule is often repeated. Over the years, I have had many expensive lessons that 10% is way too much to risk on any one trade. Professional traders only risk a very small amount of capital on any one trade and a small maximum amount on all open trades. Three percent maximum capital exposure on any one trade and 6% maximum exposure on all open trades is the accepted standard, and it is a good one.

The maximum exposure should be a percentage of the account equity available. If your available equity is $20,000, the maximum capital exposure on a trade should be $600 ($20,000 x 3 percent). The maximum capital exposure on all open trades should be $1,200 ($20,000 x 6 percent). It's that simple. If you go over these limits, you are stacking the odds of success against you and you are not conducting your business of trading in a responsible manner.

Most traders also have a maximum loss that is acceptable for any one month. If that maximum is reached, they stop trading for the month. A maximum monthly loss must be no more than 10 percent. If closed trades have resulted in a 10% drawdown to the account in less than a month, stop trading for the balance of the month. Either you or your trading plan needs a time out. There will always be opportunities next month. Take a breather.

Maximum position size is a function of maximum initial capital exposure per trade unit. First, calculate the maximum trade capital exposure of 3% of available account balance. Then calculate the capital exposure per unit based on the objective entry price and initial protective stop. The unit could be a futures contract or per share. Finally, divide the maximum account capital exposure by the trade unit capital exposure to arrive at the maximum position size for the trade.

Figure 6.17 is 15m ES. Let's assume the S&P has made the conditions to consider a long trade as of the last bar on the chart. If the Tr-1BH entry strategy is used following

FIGURE 6.17 Calculate the Position Size

the 15m bullish reversal, a buy-stop to enter a long trade is at 1441.75, one tick above the high of the last completed bar. If the ES advances and the buy-stop is executed, the initial protective sell-stop is at 1435.25, one tick below the low. We know the objective entry and stop price before the trade is executed. We don't know if it will be executed, but if it is, we know at what price the entry will be made and what price the stop will be placed. I realize markets can gap above buy and below sell stops and you don't always get filled at the order price; it doesn't happen often in high volume, active markets and we have no control over it.

The trade capital exposure per contract is 6.5 points (1441.75 - 1435.25) or $325 (6.5 x $50). If you have a $20,000 account, what is the maximum position size? Three percent of $20,000 equals $600. Dividing $600 by $325, and rounding up, your answer is two contracts. You can have a maximum of two contracts for this trade. If you were to put in a buy-stop order to enter a long trade for more than two contracts, you have no business with a trading account. You don't understand one of the most important principles of the business of trading: capital preservation. One part of capital preservation is to limit the potential loss on any one position to a relatively small amount. The maximum

FIGURE 6.18 Position Size for Long Google Position

position size is the maximum capital exposure allowed for the available account capital divided by the per unit capital exposure.

Figure 6.18 is Google daily data. Let's say you've been following Google for a couple of years. You missed buying it at $200, missed again at $300, and missed again at $400. Each time it rallied $100, $200, and more in a matter of weeks or months. Not only are you not going to miss buying Google again after it completes its next correction, but you are going to load up for a big gain to make up for the earlier missed opportunities and to set yourself up for early retirement! As of the last bar on the Google daily chart, if Google just takes out the potential Wave-B swing high, an ABC correction should be complete and off goes Google for another quick $100 to $200 gain. If you have $50,000 of available capital, what is the maximum number of Google shares you can buy with the swing entry strategy to enter above the potential Wave-B swing high with an initial protective sell-stop one tick below the minor swing low at 505.79?

The maximum number of shares you can buy is 72! The maximum capital exposure for any one trade is $1,500 ($50,000 x 3 percent). The trade unit capital exposure is $21.05 ($526.83 - $505.78). The maximum number of shares you can buy is $1,500 divided by

$21.05, or 72 shares. If you buy 73 shares, please, close out your account right now. Even if you get lucky with Google, you will eventually lose most or all of your account because you have broken an inviolate rule of capital preservation. You lack the discipline to make logical and sound trading decisions and are playing at something other than real-world, professional trading. You have risked more capital than allowed by any logical trading plan.

How to Calculate Maximum Position Size:

Available Capital x 3%

= Maximum Position Size

Capital Exposure per Unit

If this math confuses you, stop trading right now. I mean it. You need to be able to understand simple concepts and mathematics to be a successful trader. And this is as simple as it gets.

Years ago, I set up a simple spreadsheet to calculate maximum position size. All I have to do is enter the entry and stop price, value of each tick, and the account balance, and it gives you the maximum position size. You can set up a simple spreadsheet yourself or you can download one in MS Excel from In most cases, you won't need a spreadsheet or even a calculator to quickly figure out the maximum position size. It is not very complicated.

The maximum capital exposure for all open positions should be 6% of available capital. Never get beyond this limit. Always remember, capital preservation is critical to success. All successful traders limit the potential loss on any one trade to a relatively small amount. Limited capital exposure on any one trade does not guarantee success, but it will give you the opportunity for success.

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