Position sizing is the art of calculating your trade size in units. This helps you as a trader keep track of your losses and your expected profits so as not to blow your account. This skill is vital, especially for day traders and scalpers who enter in numerous short-term trades.
You could identify the best trade entry and exit positions, but if your trade size is too big, you’ll end up risking too much, and one wrong market move is likely to clean out your account. If your trade size is too small, you’ll be risking too little, and the winning percentage will likely be insignificant.
Your position size is dependent on the number of lots and the lot size you trade with. Typically, a micro lot represents 1,000 currency units, a mini-lot 10,000, while a standard lot comprises 100,000 units. With this in mind, let’s look into how to calculate your risk.
Setting up a per trade risk limit
This is the first step in determining your position size. Your risk limit is determined by your account size and the maximum percentage risk you decide to take on. A good rule of thumb is to never let this risk percentage per trade exceed 1% of your equity or account balance. This means that if you have a $20,000 account, you can risk up to $200 on a single trade. If you prefer to use a 0.5% risk, then you’ll be risking $100 per trade.
Rather than use percentages, you can set your risk to a dollar amount. For instance, you may choose to only risk $50. As long as the equity in your account is $5,000 or above, your risk is within the 1% limit. A good practice is never to vary this risk whenever you trade. However, many other variables may change. In other words, do not risk 3% on one trade, 0.5% on another, then 2% on another. When you choose your desired maximum risk level, always stick to it.
Calculate your pip risk per trade
A pip (percentage in point) is the smallest change in the price of a currency pair. For most pairs, a pip is equivalent to a price movement of 0.0001. For pairs involving the JPY, one pip is 0.01. The pip risk you take on for each trade is the difference in pips between your entry point and your stop-loss.
A stop-loss is a limit placed at a distance from your entry point so that it closes your position if the market goes against you. It stipulates the maximum loss you can withstand before getting out of the trade. Depending on whether you’re entering a long or short trade, your stop-loss should be below or above your entry point, respectively.
To minimize your loss, you’ll want to place your stop loss as close to your entry as possible. However, it should not be so close that it closes your position prematurely before the movement you’re expecting occurs. Once you determine the ideal distance between your entry and stop loss in pips, you’ll need to calculate the dollar value of your pip. As aforementioned, this value is dependent on your lot size.
Calculating the dollar value of a pip
If the currency pair you’re trading has USD as the quote currency, and your account is funded in dollars, the monetary value of a pip is fixed for different lot sizes. If you’re trading a micro lot, a single pip is worth $0.10. For a mini lot, a pip is equivalent to $1, while a standard lot’s pip is valued at $10.
However, if your account is funded in dollars but your quote currency in another currency, you have to multiply the above-mentioned pip values by the exchange rate of the USD against your quote currency.
For instance, say you’re trading the EURAUD pair. At the time of writing, the USDAUD pair is trading at $1.3712. Therefore:
- For a EURAUD micro lot, a pip will be worth $0.10 * $1.3712 = $0.14.
- For the pair’s mini lot, the pip value is $1 * $1.3712 = $1.37.
- For its standard lot, one pip is valued at $10 * $1.3712 = $13.71.
From this step, we can now calculate our position size.
Calculating the position size
Position size is calculated using the formula:
Pips risked * pip value * lots traded = amount risked.
In this formula, the position size is the number of lots traded. Let’s assume you have $20,000 in your account, and you intend to limit your risk to 1%. That means that the maximum amount you can risk is $200 per trade. You buy the EURUSD pair at $1.4021 and position your stop loss at $1.4011, a risk of 10 pips. Since you’re dealing in mini lots, each pip in price movement is worth $1.
Going back to our formula:
10 * $1 * total lots traded= $200.
Dividing both sides by $10, you get:
Total lots = $20.
Typically, 10 mini lots are equivalent to one standard lot. Thus, you can choose a position size of 20 mini lots or 2 standard lots.
Now, what if you’re trading the EURAUD pair? Again, let’s assume you’re risking 10 pips. From our formula:
10 * $1.37 * lots traded = $200
This gives our traded lots at 14.60.
Therefore, for this trade, you can choose a position size of one standard lot, four minis and sixty micro lots, or you could go for 14 mini lots and sixty micro lots.
Conclusion
Before you can start trading forex, you should be capable of calculating position sizes in your sleep. This is because position sizing is a vital step in managing your risk, lack of which is the main reason most people blow their accounts. With this skill in your arsenal, even if the market goes against you, at the very least, you get to live to trade another day.
