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Forex Essentials Course: 21 lessons to get started in Forex

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20. Portfolio Management − Position Sizing and Stop Losses

Tue, Jun 10 2008, 08:32 GMT
by PFX Team

LearningMarkets.com

Right-sized trades can be the difference between loss and gain

Position sizing is the process of determining how much to invest, or risk, in any single trade. Position sizing is different for active trading, versus longer-term investing. In the case of short-term trading, it is usually a function of how much you could lose if the trade went bad.

In longer-term investing strategies, position sizing is a bit more complicated and may depend on the strategy at play. In this section, we will focus on sizing positions for short-term trades.

Decide your risk tolerance, and stick to a plan

The benefit of position sizing is to help you predict and control the affect your trades have on your portfolio’s value. Too many traders invest inconsistent amounts in each trade.

Being inconsistent, or over investing in a single trade, will lead to draw-downs in your account that could wipe you out. Knowing how much you have at risk in a single trade compared to your total portfolio will help your investing become much more stable.

Good traders sometimes differ on how to calculate the risk, or maximum risk, of any particular position. We believe using the distance between your entry point and your stop loss is the most effective way to determine the maximum risk amount.

To size your position, you need to know how much money you have in your account, what percentage of your account you are willing risk and what your stop loss is. Imagine that you have an account with $10,000 in it and you are willing to lose 2 percent in a bad trade. You are considering a long position on the EUR/USD at 1.5000 and feel you need a 50-pip stop loss for that trade. You are now ready to calculate your position’s size.

Formula for calculating a position’s size:

(Account Value x Portfolio Risk %) / $ value of stop loss = Position size
($10,000 X 2%) / $50 = 4 mini lots

We use the stop loss to calculate maximum risk in the forex because a forex position is a margin position. That means that there is an obligation on the trader’s part to make good on losses, but there isn’t a transfer of ownership in the currency. You are not actually taking possession of $10,000 worth of currency when you trade a mini lot. What you really own is your obligation, and therefore your position sizing should be based on this rather than the entire notional value. This is unlike a stock trade, where you could ask for delivery of the stock certificate itself.

Here are answers to common questions we get about position sizing:

1. What if I only have $1,000 in my account?

We know that there are many traders in love with the forex who have very small account balances. This is not uncommon. Many dealers report average account balances of less than $10,000. If you are in this situation and you want to keep your risk low while you keep depositing money in your account, work with a dealer that offers fractional lot sizes. Many dealers have lot sizes much smaller than 10,000 units.

2. Why not increase the percentage at risk when I am very confident in my trade?

The key to effective trading is consistency. If you have a particular setup or system that you are extra confident about, make sure you have the experience to back that up. If you have a high-probability trade, always trade the same fixed risk amount in that trade. Inconsistency will disrupt your equity growth and can hurt your trading mentality.

3. How do I account for slipped stops?

We have made a big assumption here by assuming that the amount between your entry price and your stop loss is the most you can lose. We realize stops can be slipped. It’s rare, but when the market gets really volatile, it can happen. You will find this is much more common with very tight stops during extreme periods of market volatility. The wider your stop is, which usually accompanies a longer-term outlook, the less likely you are to experience slippage.

This is one argument for the use of options as a speculative alternative. A long option position’s max loss is capped at the amount paid for the option. You cannot lose more than what you paid.

If you were trading a long position on the EUR/USD and simultaneously bought a long put option to protect the position, you could calculate your max loss as the time value portion of what you paid for the put. If all the other variables were held constant, and the premium for the put was $100 per mini lot, you would be able to buy 1 mini lot.

($10,000 X 2%) / $100 = 2 minis

Develop your own risk tolerance and stop-loss formula

Watch the video below to see more about learning to set your stop losses and calculate your risk tolerances.

Forex Essentials Course - 21 lessons:

Published on  Thu, Nov 20 2008, 09:42 GMT