The Steps to Proper FX Position Sizing
05/16/2014 9:00 am EST
To survive the sometimes difficult learning curve, new forex traders can follow this "ladder" approach to position sizing and will be better able to limit the inevitable losses and preserve their trading capital.
One of the main topics of conversation that I have with new traders or students at Online Trading Academy is about the quest for trading’s "Holy Grail." While most are interested in a combination of technical analysis studies with supply/demand and a trend indicator or three, the actual Holy Grail is none of the above. In fact, it is much easier!
The real Holy Grail is proper risk management. That’s it. End of article; see you next time!
Actually, it is a bit more complicated than that. As we’ve mentioned numerous times, the two main traits that successful traders have in common is that they cut their losing trades early and let their winners run—usually with a reward/risk ratio of 3:1.
In this week’s article, I’d like to go a bit more in depth about position sizing as you are learning to trade.
Learning to trade is much like learning anything new in life; riding a bike, playing golf, or playing a video game. The main difference is the fact that you can lose money while you learn—sometimes a lot of money!
In fact, some people lose, or "blow up," their entire trading account while they are learning this great thing we call trading. I always recommend that new traders start trading very small position sizes while they are learning. Here is a scale, or "ladder," that we use in class:
- Position Size: Demo, to get a baseline
- Duration: 20 trades, or two weeks, whichever is longer
During this period, I want you to keep track of a few performance measures: your win/loss ratio, average winning trades, and average losing trades. For example, after 20 trades, you may have ten winners and ten losses with an average winning trade of 25 pips and an average losing trade of ten pips. This would be a profitable "baseline" of your performance.
After you have a profitable baseline in the demo account, it’s time to jump into the real live money trading! So, how big of a position size should you take? A common amount of risk we recommend is 1%-2% of your aggressive portfolio value.
This means that if you have a $10,000 forex trading account, we don’t want to risk more than $100-$200 per trade. What I would prefer new traders do is start with an extremely small position size of one mini lot, if possible. (With smaller accounts, you may want to also consider micro lots.)
With one mini lot of the EUR/USD, one percent of the above-mentioned account would mean a stop loss of 100 pips (each pip is a dollar in this currency pair). If the trade you are considering only needs a stop loss of 20 pips, you could trade five mini lots, according to the 1% rule. However, you haven’t earned your trading stripes yet!
NEXT PAGE: How to Safely Graduate to Larger Position Sizes|pagebreak|
Stick with the one mini lot because live money trading affects us differently than demo trading does. So, how long should you trade one mini lot? Just like you did in the demo platform; 20 trades, or two weeks, whichever is longer.
Keep track of your performance; i.e. is it profitable? Was it close to your baseline from the demo account? If so, congratulations, you are doing it right! Now you may trade two mini lots. Guess how long? Two weeks, or 20 trades, whichever is longer.
You can probably guess what happens next: three mini lots, then five, seven, ten, 15, 20, 25, 30, etc..
Depending on your trade management style (all in/all out, scaling in and out), you may want to consider going from ten mini lots to one standard lot. Some brokerage firms offer better pricing for standard lots versus mini-lot accounts.
Two Main Reasons to Follow This Plan
There are two main reasons for this position sizing plan. The first is to have very small risk and losses until you get good at trading. What is the point of being a good trader if you’ve blown up your trading capital while you were learning?
Do you like working for someone else, scraping together a few dollars here and there to fund another trading account? The whole point is to have capital to trade and to change your life; not to watch the demo account video game!
The second reason I recommend this position sizing "ladder" is your emotions. The market doesn’t care about your position size…only you do. If you are down 20 pips on the EUR/USD with two mini lots, it’s only $40. You probably have that much money in your change bucket at home!
But, if you are down 20 pips on five standard lots, you are now talking about $1,000. And yes, you could be down that 20 pips in a few seconds! That $1,000 deficit staring at you in the face might be difficult for you to handle in the beginning of your trading career. The market doesn’t care about it, but you do!
So, the plan is to build up some emotional tolerance to the potential negative figures in your profit and loss column. Over time, that 20 pips is all you will look at; not the money. It won’t matter to you if a trade goes against you $40 or $1,000 because you are trading the chart, not the red and green profit and loss figures on the screen.
Keep doing what you are good at and eliminate the bad habits. With proper position sizing, you will be able to keep the risk low until trading becomes simple!
By Rick Wright, Instructor, Online Trading Academy