Position sizing in Forex is another concept in trading that is often overlooked. However, position sizing plays a very vital role in knowing their potential risk and potential profit.
Position sizing helps determine how much capital you should allocate to a particular investment.
In this article, we discuss the meaning of position sizing, the factors that affect position sizing, position sizing techniques, the importance of position sizing and useful tips for proper position sizing.
Deciding how much money to put into a specific investment or trade is a crucial part of managing risk in trading and investing. This is called position sizing.
Position sizing is like figuring out how many units or shares to invest in a currency pair or stock based on the size of your trading account and how much risk you're comfortable with.
The name "position sizing" makes it clear—it's about determining the size of a position in your overall investment portfolio. It helps investors and traders know the right amount of a security they can buy. This, in turn, lets them control risk and make the most of potential returns.
The goal of position sizing is to help investors decide the perfect amount of their money to use in a trade, considering their risk tolerance, objectives, and the current state of the market.
This helps traders and investors not to exceed a predetermined limit of loss.
There are three major factors that a trader needs to consider when determining the optimal position size for a trading position. They are;
To determine the appropriate position size, a trader must first identify their account risk. The amount of money you're comfortable risking on each trade is known as your account risk. This is typically a percentage of your total trading capital.
Most individual traders stick to risking no more than 2% of their trading capital on any single trade. For instance, if you have a $50,000 trading account, you wouldn't want to risk more than $1,000 on a particular trade (2% of $50,000).
Even in the scenario of facing 10 consecutive losing trades, following the 2% rule would mean a loss of only 20% of your total capital ($1,000 x 10 trades).
However, when trading on a funded account, it is advisable to risk less than 1% so as to increase the number of traders that can be placed.
Hence if a $50,000 funded trader risks only 0.5% of their account size which is $250, the trader still has about twenty consecutive losing trades before they can fail the challenge.
Once you've determined your account risk, the next step is to decide where to place your stop-loss order for a specific trade.
In forex trading, trade risk is calculated as the difference in dollars between your intended entry price and the stop-loss price.
For example, if you plan to buy a currency pair at 1.3000 and set a stop-loss order at 1.2980, your trade risk would be 20 pips.
With the knowledge of your account risk and trade risk, you can now calculate the correct position size.
Let's say your account risk is $250, and your trade risk is 20 pips.
To determine the position size, divide the account risk by the trade risk. In this case, it would be $250 divided by 20 pips, resulting in a position size of $12.5 per pip.
Proper position sizing is the backbone of risk management. If you aren't aware of the position size you're taking on a trade, you will not be able to manage your risk properly.
It helps traders and investors limit potential losses by ensuring that no single trade can excessively impact the overall portfolio. By allocating a specific percentage of capital to each position, traders and investors protect themselves from significant financial setbacks.
Trading can be emotional for traders sometimes, especially when on a losing streak. However, when traders adopt a consistent position-sizing strategy, they can maintain emotional discipline.
Emotional decision-making, such as overleveraging on a single trade, or revenge trading can be lessened by following a well-defined position sizing plan.
Position sizing helps traders stay consistent in strategy execution. Traders who follow a systematic approach to determining the size of their positions are more likely to stick to their trading plan, avoiding impulsive and inconsistent decision-making.
When traders control the size of each position, they contribute to the long-term sustainability of their portfolio. This disciplined approach helps avoid portfolio-destroying losses, allowing for gradual and steady growth over time.
For the sake of your knowledge and possible implementation, we shall discuss different position-sizing techniques.
You decide on a specific amount of money to use for each trade. For example, you might choose to invest $100 in every trade. This keeps your risk consistent, but it doesn't consider the fact that different investments can be more or less risky.
You allocate a certain percentage of all the money you have for investing to each trade. If you decide to risk 2% of your total money on a trade, the amount you invest changes based on how much money you currently have. This helps adapt to changes in your account but can expose you to more risk during losing streaks.
You risk a fixed portion or fraction of your total money on each trade. For instance, if you choose to risk 1% of your money on a trade, the actual amount changes as your account value changes. This approach tries to find a balance between consistency and flexibility.
This strategy looks at how much the price of what you're trading tends to go up and down. If it's very jumpy, you might invest less; if it's more stable, you might invest more. It adjusts your investment based on the usual price movements of what you're trading.
The Kelly Criterion is a formula that helps you decide how much money to put into each trade. It looks at the chance of making money and the potential reward compared to the risk. It aims to help your money grow over time.
f* = (bp-q)/q
However, it's important not to invest the entire suggested amount to avoid big losses.
This is the first and individual assignment that traders need to carry out on themselves to determine how much (this could be a fixed price or percentage) of their capital they can risk. This would enable them to shape their position sizing strategy in a way that will suit them personally.
Position sizing calculator helps traders by passing the hurdles of having to calculate their position size themselves, which could have caused them to miss some trade opportunities.
At Goatfunded trader, we have provided our traders with position size calculators here on our blog in order for them to enjoy a seamless trading experience.
Traders should endeavour to stick to their preferred position size that they have determined personally. This will foster discipline in their trading career.
In summary, position sizing is crucial for managing risk in trading. It helps you decide how much money to invest based on your account and how much risk you're comfortable with.
This ensures you don't lose too much in a single trade. Following a consistent position sizing plan also helps control emotions during trades and supports long-term growth.
There are different techniques, like investing a fixed dollar amount or a percentage of your portfolio.
Defining your risk tolerance and staying consistent with your chosen size are key for a disciplined trading approach.