Length : 5.30 Minutes
Risk Management (RM) - Position Sizing (Part 3)
We have already covered the two important aspects of risk management, diversification and drawdowns. In this topic we are going to discuss position sizing.
As a trader, when it comes to risk management size matters!
In fact your position size, or trade size, is more important than your entry and exit point. You can have the best forex strategy in the world, but if your trade size is too big or small, you will either take on too much or too little risk. The former scenario is more of a concern, as risking too much can bleed your account to death quickly.
Your position size is how many lots (micro, mini or standard) you take on a trade. When it comes to position sizing two factors has to be taken into consideration, amount of risk that should be taken per trade and the maximum amount of risk when multiple trades are running. It is important to understand that position size and risk amount are not the same thing.
Set Your Account Risk Limit per Trade
Ideally your risk exposure per trade should be 0.5% of your account and the maximum amount of risk at a time when you have to open a multiple trades on different currency pairs at the same time should not be more than 2% of your account capital. Let’s assume you have $10,000 in your account, you could risk $50 per trade if you risk 0.5% of your capital on a trade and the maximum risk would be $200 which equals to 2%.
For instance, if you have 4 different trade setups on 4 different non-correlated currency pairs at the same time like, EUR/USD, GBP/JPY, CHF/NZD and AUD/CAD, then you have to risk only 0.5% of your account capital per each of the four trades. So, even if your analysis was wrong on all the four trades, you will be only risking 2% of your total account.
Let’s take a look at another scenario, let’s say you have two trade setups on two highly correlated currency pairs like EUR/USD and GBP/USD, in this case you have to consider these two trades as one trade and risk only 0.25% of your account capital per each of these two trades. This is due to the fact that these two pairs are highly correlated and they both move in the same direction, and there is no diversification here.
As you may know from the “Diversification” topic, you should not trade a same currency more than once at the same time, and if you do so, you have to adjust your risk level and position size accordingly.
It is important to be consistent with the level of risk that you take per trade, you should follow the predefined risk level that you set for yourself religiously.
You should use the latest updated account balance ideally at the end of each month to calculate the risk level, for example if you made $1000 for this month, then you can add the profit to your initial capital and then calculate the risk based on the added amount.
We strongly recommend that if you have only one trade setup at a given time do not bet the full 2% risk allowance per capital in one single trade and try to diversify it to minimise your risk exposure.
Determine position size to place stop loss
Once you decide where you plan to place your stop loss, then you can calculate the ideal position size. Depending of the strategy and the particular trade setups, stop loss distance may vary. For, one trade could be 10 pips away, and for another pair could be 50 pips away and it totally depends on the strategy.
To calculate the ideal position size you should follow the formula below:
Pips at risk x Position size (Lot) x Pip value = predefined $ amount at Risk
Step 1: Calculate the dollar amount of the risk allowance per trade.
For example: If you risk 0.5% of your $10,000 account capital, then the dollar amount equals to $50.
Step 2: Decide where you need to place your stop loss.
Let’s assume, stop loss is 20 pips. And the pair you are going to trade is EUR/USD.
The pip value of EUR/USD for a micro lot equals to 1.
Pips at risk x Lots traded x Pip value = predefined $ amount at Risk
20 x Position size x 1 = 50
The position size equals to 2.5 mini lots (Volume 0.25 on Metatrader for a standard account).
Therefore based on the pre set risk allowance per trade, which in this case is 0.5% of account capital or $50, your ideal position size would 2.5 mini lot. In this case if the trade goes against you and your SL, your loss will be equal to your risk tolerance of $50.
The position size, which is considered in lots in the formula is linked to the pip value inputted into the formula. If you input the pip value of a micro lot, the formula will produce your position size in micro lots. If you input a standard lot pip value, then you'll get a position size in standard lots.
Let’s assume you input $10 for the pip value, which is for a standard lot on EUR/USD. The formula produces the position size as 0.25. This is also correct because as it was said earlier the position size is linked to the pip value. Since you input standard lot pip value, then the position is also 0.25 standard lot that is also equal to 2.5 mini lots.
You can refer to the 3 different examples presented in the table below for better understanding: