Questions that are often asked by newer traders are "How do I calculate my pip size when trading Forex?" and "How do I know my position size when trading Forex?". Knowing the answers to these questions is crucial for risk and money management.
Position Sizing
Is position sizing needed?
Yes, most definitely. Good position sizing is part of strong money and risk management. Without a position sizing strategy, traders and investors can lose too much capital. Position sizing allows a trader or investor to have sufficient capital to carry-on making trades after a losing streak. If a position sizing strategy is not followed, a trader or investor may have an empty trading account each time their trading strategy has a draw-down.
What are some examples of position sizing strategies
Calculating your position sizing is relatively straight-forward and should not require much effort. There are 2 main common position sizing strategies that Forex traders adopt. These are as follows...
Risking a percentage of your account per trade
Allocating a certain percentage of your account per trade is a common way to manage position size. The percentage you allocate will be determined on the performance and draw-down size of your trading strategy and your psychological ability to manage losses and losing streaks. For day traders, the percentage of account risked usually varies from 0.1%-0.5% per trade. For longer-term traders, the percentage of account risked usually varies from 0.5%-1.5% per trade.
Let's say you have an account size of $5,000 and you decide to risk 1% of your account per trade. 1% of $5,000 is $50 (5000*0.01), so you will be risking $50 per trade. Without taking into consideration the margin, your account can potentially take 100 consecutive losing trades before there is no money left in the kitty. This is a great way to manage your account balance. Compare this to a trader that decides to risk anywhere from $500 to $1000 per trade. Without taking into consideration the margin, this trade could potential be out of business within 5 losing trades. This is not a great way to manage your account balance.
Martingale position sizing
Another common position sizing strategy is the martingale technique. This strategy in it's most basic form is basically doubling your position size each time you have a losing trade. The belief is that you will eventually have a winning trade and "doubling-up" will recover previous losing trades and put your account back into profit.
Though the strategy seems to be based on common sense, the trader or investor will quickly run out of capital as it will not take too many "doubled-up" positions until there is insufficient capital in the trading account.
Our advice is that martingale strategies often do not help to manage risk but add to it. Though the returns from martingale strategies are promising, the long-term impact is usually devastating.
Always ensure that potential reward outweighs the potential risk
Another crucial part of strong position sizing is to ensure that the potential reward from each trade outweighs the potential risk. Let's go back to the 1% of account $50 per trade example. If the trader ensures that each trade he enters could result in a return of $100, he or she can quickly and effectively build capital and profits in his or her trading account. Compare this to a trader that is risking the same amount of capital per trade but earns $10 for each profitable trade. 1 losing trade will wipe-clean 5 winning trades!
Generally, risk and reward is written by using risk to reward ratio. Meaning that the trader that wins $100 per winning trade, has a risk to reward ratio of 1:2. Perhaps he closes a very profitable trade at $250. This would be displayed as 1:5 RR (Risk to Reward).
Learn about calculating PIP size, click here