Why right position sizing is so crucial? This is the essential step to one of the most important things for trader - staying calm and reasonable. The only approach that can prevent from vast losses and disappointment in trading is based on simple formulas.
The following article will provide beginner traders with a step-by-step tutorial on position sizing in Forex. Before we jump into the tutorial, let's briefly explore exactly what forex trading position sizing is.
What Is Position Sizing?
Put simply, position sizing is the size of a position in an investment or trading portfolio. It may also refer to the amount of dollars a trader or investor is about to trade with. Position sizing is used to assist with identifying the amount of units of securities that a trader may be able to buy. This enables the trader to maintain some degree of control over the risk involved with their trades, and of course, to increase their chances of making higher profits.
The ability to correctly size a forex trading position enables a trader to attain a certain risk level within their trade. Without the ability of fully understanding how to size your trading positions, it's next to impossible to be able to become a consistent trader, and therefore, to make consistent profits.
There is a step-by-step guide on how to define the position size correctly while trading. Follow each step and test in on risk-free demo!
#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.
If you are feeling more confident with position sizing and would like to try it out, why not start by opening a demo MT4 trading account with MTrading?
By practicing what you have learnt in a demo account first, you will be able to test out the effectiveness of different position sizes, and therefore, you'll be able to prepare yourself for trading in the live markets, without having to risk your capital straight away!
Why is consistency important in position sizing?
We briefly touched on this at the start of the article, but to explain a little bit further, maintaining the position size of trades is important because it enables you to keep your trades consistent, which also enables you to slowly and steadily increase your trading account, whilst also avoiding high levels of market volatility.
Inconsistency in position sizing leads to mistakes such as putting too much capital into certain trades that perhaps shouldn't be made. It will take some practice to figure out the correct amount of lots to buy or sell for a trade, but by setting the stop loss correctly and being consistent with the position sizing, you will begin to slowly get the hang of it.
Position sizing is the only element of a trade that you have 100% control over, so it makes sense to spend time understanding how to do it properly, so that you can maximize its effectiveness.
Examples of Position Sizing Strategies
Here are some examples of regularly used position sizing strategies:
- Fixed Lot Position Sizing: This involves selecting a 'fixed' amount of lots and is suited to traders who are likely to make frequent withdrawals from their trading account.
However, a downside of this strategy is the fact that it does not allow the trader to hold a constant leverage while the trader's account balance changes. This can lead to much larger losses, and it can become an increasing problem if the trader is continually losing.
- Fixed Ratio Position Sizing: in this position sizing strategy, there is a direct link or relationship between potential growth and the perceived risk for a trade. This position sizing strategy enables the trader to pinpoint more accurately the best times to either increase or decrease their lot sizes.
Well, now it seems like you are fully packed for your test order on our free demo account! When you open an account, you instantly get access to trading on a real trading platform in real market conditions without any risk. We offer test 5000 USD to your demo account, so you could test different strategies. Moreover, our personal managers are happy to guide you through any upcoming questions.
It may be a good idea to read something else, while you are still a beginner. Why don't you take a closer look at 5 basic forex tools now?
We wish you a good trading luck and looking forward to see you trading with us.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.