The Right Way to Calculate Your Risk in Forex Trading
12/08/2010 12:01 am EST
Most traders begin trading by risking one lot (or mini lot) for each trade. Let's assume that the beginner already has learned to plan their entry and exits ahead of time. Regardless of the magnitude of the trade, they will frequently use the same size position for every trade. Therefore, a trade with a 200-pip stop will carry five times the risk of a trade that has a 40-pip stop. Therefore, an uncontrolled variable can greatly adjust results. To eliminate this variable, we simply adjust our position size so that every trade carries a similar amount of risk. It is probably best to risk one to three percent of the account balance in order to have a reasonable level of risk on each trade.
Calculating position size is easy. First, take the account balance and multiply it by your predetermined risk level. For our example, let's say that our trade plans to risk three percent of their account on each trade. Let's also suppose that our trader has a $100,000 account balance.
$100,000 x 3% = $3,000
Therefore, our trader will look to risk approximately $3,000 on each trade. Next, we have to calculate the amount of risk per lot for each trade. This can be quickly determined by drawing the value calculator (located on the left sidebar of DealBook 360) from the entry to the stop. Let's say that our trade utilizes mini lots (10,000 unit lot size) so they are able to precisely risk 3% each time. Let's look at the following example to see how this works in the real world. Both of the trades below were posted on FX360 recently. Example one is a trade on the daily chart, and example two is a trade on a 15-minute chart.
On example 1, we see that the distance between the entry and the stop is 230 pips. Therefore, on the EUR/USD, the risk per mini lot is $230. Then our trader divides the risk per trade ($3,000) by the risk per mini lot for this particular trade ($230).
Our trader rounds down to 13 mini lots for this trade. The idea is to get as close to risking three percent of the account as possible without going over.
On example two, we see that the distance between the entry and the stop is 20 pips. Therefore, on the EUR/USD, the risk per mini lot is $20. Our trader once again divides the risk per trade ($3,000) by the risk per mini lot for this particular trade ($20).
For this trade, our trader will trade 150 mini lots. It quickly becomes apparent that example two requires a much larger position in order to keep each trade weighted equally. Let's take a look at the results. Example one was stopped out with a loss of $2990 ($230 risk per mini lot multiplied by 13 mini lots). Example two reached the profit target with a gain of $6,450 ($43 profit potential per mini lot multiplied by 150 mini lots). The result is a net gain of $3,460, or 3.46% of the initial account balance (assuming we began with the same account balance for each trade).
If the trader had not properly adjusted position sizes and used one standard lot (or ten mini lots) for each trade, example one would have resulted in a 230-pip loss and example two would have resulted in a 43-pip gain. The net result would be a loss of $1870, or 1.87% of the initial account balance. The random variable of trade magnitude was not controlled, and a pretty large price would be paid for it. There could also be times where the longer-term trade won and the shorter-term trade lost, but there is no way to control that variable.
Therefore, we eliminate it by adjusting our position size so that each trade carries roughly the same weight. With this method you can be sure you are not risking more than you want to, regardless of the currency pair(s) you trade.By Bradley W. Gareiss, technical analyst, GFTForex.com