#1 Stop loss distance
Many traders make the mistake of setting their stop loss in the final stages, when it is far more sensible to actually begin with this step. Therefore, before a trader enters their trade, they should know where they are going to place their stop loss.
Once this is done, it is then possible to measure and establish how much distance there is between the level of the stop loss, and the entry price level. Your stop loss exists to protect you from making significant losses, so make sure that you do not manipulate this level in order to achieve a better position size.
In forex trading, the stop loss distance is typically gauged in pips, whereby 1 pip = 1 price per unit. If we take the EUR/USD forex currency pair as an example: if the price moves from 1.8000 to 1.8001, this would equate to 1 pip.
#2 Defining the level of risk in your trade
This is a pretty simple step, how much are you prepared to risk in your trade? Or rather, how much are you prepared to lose in the pursuit of a winning trade? It's typical for traders to risk a certain proportion of their trading account on a trade that they deem a winner.
It's important not to purchase random lot sizes and then proceed to adjust your stop loss in order to reach a specific level of risk, i.e where the risk and reward might be higher . Stop losses should be placed at a sensible price level in relation to the chart you're working with.
Moreover, trading risk is normally determined by the quality of the trading setup - meaning that if you decide to risk more on a 'solid' setup , it makes sense not to make unnecessary risks on lower quality setups.
This is otherwise known as a 'variable position sizing' and is used regularly by professional traders, as well as in other forms of activities that involve odds.
#3 Understanding pip values and lot sizes
Position sizes are based on the number of 'lots' that you choose to trade with. There are three types of lots: Micro Lots, Standard Lots, and Mini Lots.
- Standard Lot size is: equivalent to 100.000 of the currency being bought or sold.
- Mini Lot size is: equivalent to 10.000 of the currency being bought or sold.
- Micro Lot size is: equivalent to 1.000 of the currency being bought or sold.
Pip values change according to the size of the lot that you are trading with. Here are some examples to help you understand:
- 1 Standard Lot: 1 pip = 10 USD;
- 1 Mini Lot: 1 pip = 1 USD;
- 1 Micro Lot: 1 pip = 0.10 USD;
- 1 Nano Lot: 1 pip = 0.01 USD.
Here's a small chart that helps to understand the size of lot on Forex and pip value.
10 mini lots are equal to 1 standard lot, and 10 micro lots are equivalent (the same) to 1 mini lot. The values of pips vary according to the different types of currency pairs you are trading with. It's important to check the pip values for different currency pairs before you start trading with them.
#4 Locating the ideal lot size by using stop distance
The final step involves putting all of this information together and then figuring out the amount of lots you need to purchase (sell) in order to reach a specific risk size.
The forex position sizing formula typically looks something like this:
Trade risk (per trade) / stop loss in pips = Mini lots
For instance, if you would have $2,000 USD with a 2% risk for every trade, this would equate to $40, and the stop loss distance would be 50 pips.
The result of this would be: $40 / 50 = which would equal 0.8 - meaning that you would need to purchase 0.8 mini lots (or 8 micro lots).
Furthermore, you can also create your own forex position sizing spreadsheet or 'cheat sheet' for the purpose of helping you to achieve greater consistency within your position sizing decision. This can help you to save some time by providing you with a range of different position sizing options all in one place, which you can regularly update here and there to reflect new potential options.