Sunday, August 28, 2011

Calculating Position Sizes

To make things easier for you to understand, as usual, we'll be explaining everything with an example.
Newbie NedThis is Newbie Ned.
Long time ago, back when he was even more of a newbie than he is now, he blew out his account because he put on some enormous positions.

It was as if he was a gun slinging cowboy from the Midwest - he traded from the hip and traded BIG.
Ned didn't fully understand the importance of position sizing and his account paid dearly for it.

In the following examples, we'll show you how to calculate your position size based on your account size and risk comfort level.
Your position size will also depend on whether or not your account denomination is the same as the base or quote currency.


Account Denomination the same as the Counter Currency

Newbie Ned just deposited USD 5,000 into his trading account and he is ready to start trading again. Let's say he now uses a swing trading system that trades EUR/USD and that he risks about 200 pips per trade.

Ever since he blew out his first account, he has now sworn that he doesn't want to risk more than 1% of his account per trade. Let's figure how big his position size needs to be to stay within his risk comfort zone.
Using his account balance and the percentage amount he wants to risk, we can calculate the dollar amount risked.

USD 5,000 x 1% (or 0.01) = USD 50
Next we divide the amount risked by the stop to find the value per pip.
(USD 50)/(200 pips) = USD 0.25/pip

Lastly, we multiply the value per pip by a known unit/pip value ratio of EUR/USD. In this case, with 10k units (or one mini lot), each pip move is worth USD 1.

USD 0.25 per pip * ((10k units of EUR/USD)/(USD 1 per pip)) = 2,500 units of EUR/USD
So, Newbie Ned should put on 2,500 units of EUR/USD or less to stay within his risk comfort level with his current trade setup.

Pretty simple eh? But what if your account is the same as the base currency?

Account Denomination the same as Base Currency

Let's say Ned is now chilling in the euro zone, decides to trade forex with a local broker, and deposits EUR 5,000.

Using the same trade example as before (trading EUR/USD with a 200 pip stop) what would his position size be if he only risked 1% of his account?

EUR 5,000 * 1% (or 0.01) = EUR 50
Now we have to convert this to USD because the value of a currency pair is calculated by the counter currency. Let's say the current exchange rate for 1 EUR is $1.5000 (EUR/USD = 1.5000).

All we have to do to find the value in USD is invert the current exchange rate for EUR/USD and multiply by the amount of euros we wish to risk.

(USD 1.5000/EUR 1.0000) * EUR 50 = approx. USD 75.00
Next, divide your risk in USD by your stop loss in pips:
(USD 75.00)/(200 pips) = $0.375 a pip move.

This gives Ned the "value per pip" move with a 200 pip stop to stay within his risk comfort level.
Finally, multiply the value per pip move by the known unit-to-pip value ratio:

(USD 0.375 per pip) * [(10k units of EUR/USD)/USD1 per pip)] = 3,750 units of EUR/USD
So, to risk EUR 50 or less on a 200 pip stop on EUR/USD, Ned's position size can be no bigger than 3,750 units.

Still pretty simple, eh?
Well now it gets slightly more complicated.

Don't worry though. The FX-Men got yo' back and we'll explain everything so it'll become as easy as baking a cake.

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