Volatility-based position sizing ensures that the size of each trade is proportionate to the volatility of the asset. This allows you to control the risk of each trade while adapting to market conditions.
Summary of the process:
Decide How Much You’re Willing to Risk: Set a fixed percentage of your total money to risk on each trade. A good rule is to risk only 1-2% of your account on a single trade.
- Example: If you have $10,000 and risk 2%, your risk per trade is $200.
Measure the Asset’s Volatility: Use the Average True Range (ATR) tool to see how much the asset price usually moves. ATR tells you how volatile an asset is. Higher ATR means more significant price moves and lower ATR means smaller moves.
Set Your Stop-Loss Based on Volatility: A stop-loss is an automatic order to sell when the price moves against you. Set your stop-loss at a distance based on the ATR (for example, 1-2 times the ATR). This accounts for normal price swings.
- Example: If the ATR is $1.50 and you set your stop-loss at 2x ATR, your stop-loss would be $3 away from your entry price.
Adjust as Volatility Changes: If the market becomes more volatile, your stop-loss will widen, so you’ll buy fewer [shares]. If volatility decreases, you can buy more [shares] since the price moves are smaller.
