Risk management is a vital part of every FX trader’s career. This is because the forex market is a high-risk investment, and just one bad trade is enough to end one’s trading career. For that reason, any trader worth their salt will always take measures to manage their risk for every trade they execute. Position sizing comes in handy in this endeavor, as it helps determine just how much of a currency pair one should trade at a go.
Factors to consider
Before you can compute the appropriate position size, there are a few factors you should consider. These factors will help you determine the appropriate amount of risk to take per trade, as too little risk can lead to negligible returns. Take on too much risk, on the other hand, and your account can easily be blown by one misjudged trade. Therefore, before you can embark on determining your ideal position size, you should follow the steps below.
1. Set a per trade risk limit
Now, the maximum risk you can take per trade will be dependent on your account equity. This is the size of your account balance before you place a trade. A good rule of thumb is to never risk more than 1% of your equity on a single trade. Therefore, if your account holds $500, that means that the maximum risk you can take on a single trade should be $5.
In the forex market, even the most seasoned traders will have their losses sometimes stretching into a continuous streak. By risking only 1% of your equity, you ensure that when your losing streak comes around, the prolonged losses do not clear out your account before you have a chance to recover.
Instead of using a percentage, you can also opt to settle for a risk limit in dollars or any other denomination that you fund your account with. For instance, you could choose never to risk more than $10 on any single trade. As long as your account balance does not go below $1,000, you will still be risking less than 1% of your equity per trade.
Another important practice is to ensure you stick to your guns when it comes to your risk limit. If you decide on a 0.5% risk per trade, always stick to that figure. Similarly, if you decide to go with a dollar figure, adhere to that limit for every trade you make, rather than fluctuating the amount arbitrarily. However, if your account balance dips such that your risk in dollars exceeds 1% of your equity, you should adjust the amount you risk accordingly.
2. Calculate your risk in pips
Once you have established the maximum risk, you’re willing to take, and it is now time to analyze the trade you intend to make. The risk on a trade is defined by the distance between the entry and the position of your stop loss. In currency price charts, this distance is measured in pips.
A pip is the smallest unit of change in a currency pair’s price. Now, you may have noticed that the prices of most currency pairs are quoted to four or five decimal places. In these, a 0.0001 change constitutes a pip, while any decimal places after that are called pipettes. The exception to this is pairs involving the JPY. For these, a pip movement is equivalent to a 0.01 change in price.
Thus, if your entry for a GBPCHF trade is 1.2450 CHF and you place your stop loss at 1.2440, that’s a risk of 10 pips. Once you have your risk in pips, the next step is to calculate the monetary value of a pip.
3. Calculate pip value
The value of a pip depends on the lot size you’re trading. A standard lot consists of 100,000 currency units, a mini lot 10,000 units, while a micro lot contains 1000 units. If the pair you’re trading has USD as the quote currency, the pip values for each of these lots are fixed. For a standard lot, a pip is worth $10, while for a mini lot, it is valued at $1. Similarly, a micro lot’s pip is worth $0.10.
If your quote currency is not the USD, then to obtain the equivalent pip value in dollars, multiply your quote currency’s exchange rate against the dollar with the pip value corresponding to your lot size. For instance, let’s say you’re trading a standard lot of the GBPAUD at a time when AUDUSD is trading at 0.7320 USD. In that case, a pip movement of the GBPAUD pair will be worth:
$10 * 0.7320 = $7.32.
Calculating the ideal position size
Once you have obtained the value of a pip, it is now easy to calculate the ideal size of a position to take for your trade. This position size will be in terms of the number and magnitude of lots you trade. The formula used in this calculation is:
Pips risked * monetary value of pip * lots traded = amount risked
Let’s consider an example. Imagine you’re trading the AUDUSD pair, and your account equity is $10,000. Following the 1% rule, the maximum risk you can take is $100. You short the pair at 0.7320 USD and place your stop loss at $0.7340, 20 pips away. Since your equity can only afford you a mini lot, a pip’s movement will be worth $1. Applying the formula;
20 * $1 * position size = $100.
Thus, the number of lots you can trade is 5 mini lots, which is your position size.
Conclusion
Risk management is a key component of any successful forex trader’s strategy. It involves putting a cap on the maximum risk taken per trade so as to avoid blowing one’s account. The way to do this is to calculate the appropriate position size before executing a trade. Before you can obtain this figure, you need to identify a maximum acceptable risk level, quantify your risk in pips and calculate the monetary value of each pip of movement.