Position-Sizing Strategies for Forex Traders
06/26/2013 9:00 am EST
The benefit of position sizing is to help traders predict and control the effect their trades have on their portfolio's value, and the staff at ForexTraders.com offers some methods here.
Selecting a suitable position sizing method can affect your success as a forex trader as much as choosing a direction to trade in the forex market.
As a result, experienced foreign exchange traders strongly recommend incorporating a position sizing technique into your trading plan that takes your trading portfolio size into account.
This position sizing strategy will help keep you from taking on excessive risk that may make trading losses that much harder for your account to recover from.
Position Sizing Strategies
Position sizing represents a key element of a good money management plan. Successful forex traders usually know precisely what percentage of their trading account will be placed at risk with any given trade.
They will also usually avoid extending the risk they take when trading beyond the limits of their trading account's expendable funds.
Nevertheless, increasing position sizes as your account grows makes some sense since the overall level of risk taken remains the same.
In addition, reducing the size of positions in volatile markets can cut down on risk considerably. Conversely, trading in larger sizes when the market seems more peaceful may also prove to be a profitable strategy.
Some of the more popular position sizing methods used by successful traders to manage their risk are detailed below.
Fixed Lot Sizes - Those traders who prefer to keep their trading rules as simple as possible, perhaps the simplest position sizing technique involves only trading in a certain lot size whenever positions are taken. This standard trading size should generally have a manageable risk associated with it that can be easily assimilated into the trader's account should the worst case occur. Also, as a portfolio grows or decreases in size, the trading size may be increased or reduced accordingly.
Fixed Risk Position Sizing - A somewhat more complex position sizing algorithm would involve taking positions using a risk basis calculated as a certain fixed percentage of the portfolio's total value. When using such a position sizing strategy, traders with larger portfolios would take higher risks on each position, but those with smaller portfolios would take lower risks. This assists the trader by assuring that no single position will empty their trading account.
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Risk/Reward Weighted Sizing - An added degree of complexity might be to first assess how profitable a trade might be—along with how likely making such a profit might be—to determine what position size to take. For example, a trader could take larger positions when a high-probability and high-return trade had been identified. Alternatively, smaller positions would be taken for lower-probability trades with lower returns.
Yet another technique is to use the z-score, which is the mathematical tool used for calculating the capability of a trading system for generating wins and losses in streaks. The simple formula allows us to test our performance, and to check if the streaks generated present a random pattern or not.
Position Sizing and Gambling
Forex trading has considerably more in common with gambling than with investing. As a result, it is hardly surprising that forex traders can learn from successful position-sizing strategies employed by seasoned speculators.
For example, you may want to increase your position size if you have made money trading lately or reduce it if your account has recently suffered a string of losses.
Gamblers who shoot craps also use this method by betting less money when luck seems to favor the house and increasing their bets when the house is on a losing streak.
Another position sizing technique is to take on a larger position when the trade under consideration has a higher estimated probability of success. This method has also been used successfully by poker players who tend to bet more when they are holding a better hand.
Beware of Using Excessive Leverage
Because of the nature of forex trades—which involve an exchange of initially equivalent assets rather than an outright purchase or sale of a stock or commodity—traders can sometimes leverage their margin deposits up to a ratio of 500:1 with some online retail forex brokers. (In the US, the maximum leverage is 50:1 for majors and 20:1 for minors.)
This means that a margin deposit of $1,000 can allow you to control a trading position of as high as $500,000. Nevertheless, taking advantage of this high leverage ratio can be very risky.
Clearly having access to so much leverage allows a trader to control a considerably larger position from which a proportionally greater profit can be had.
Conversely, the risk involved is also similarly higher and can easily result in the trader going out of business quite suddenly.
Of course, using high leverage in combination with a tight stop loss level may limit your trading risk to acceptable levels.
Nevertheless, most experienced forex traders prefer to keep the leverage ratio they use low in order to allow them more leeway on stop losses for the same amount of money placed at risk. This can help reduce the chances of their stop loss levels being triggered, especially in volatile trading conditions.
By the Staff of ForexTraders.com