The forex market operates within one simple rule: the rise and fall of currencies—traders who can precisely predict the course of the market with their knowledge win. However, the trader’s “knowledge” is a set of skills that requires continuous learning and upgrading. And any mistake can be costly.
One fundamental concept that traders should have at their fingertips is position sizing. While opening a new trade, a common problem that a new trader fumbles with is how much money they should allocate per trade. Traders can easily do this with the help of position sizing. It helps traders decide how much capital they should allocate to trade, keeping potential losses at bay while maximising gains.
So, it’s just maths? No, position sizing is not a mere numbers game. It is a strategic approach where a trader checks out different variants —risk tolerance, market conditions, and individual trading objectives—in allocating the size of each position. In this article, we will see how it is done and some of the top strategies to allocate position size.
What Is Position Sizing?
In layman’s terms, position trading is selecting the right number of units to buy/sell a currency pair. As stated above, this is a key concept for traders to learn because it helps manage risk and maximise profits.
Let’s understand this concept with the help of an example: –
A trader has an account balance of $10,000. He wants to risk 2% of their account on a trade in the EUR/USD currency pair. To calculate the position size, the trader needs to consider two things: the risk per trade and the stop loss level.
- Trader’s risk per trade: The trader wants to risk 2% of their account, which is $200 (2% of $10,000)
- Stop loss level set up by trader: Let’s say the trader sets a stop loss of 50 pips.
You can calculate the position size with the help of the below formula –
Position Size = (Risk per Trade / Stop Loss in Pips) * (Pip Value)
To find out the pip value, the trader needs to know the lot size they are trading. Let’s assume the trader is trading a standard lot (100,000 units). The exchange rate for EUR/USD is 1.2000.
Pip Value = (0.0001 / 1.2000) * 100,000 = $8.33
Now, the trader can calculate the position size:
Position Size = ($200 / 50) * $8.33 = 333.33 units
Therefore, the trader can open a position of 333.33 units in the EUR/USD currency pair, which corresponds to risking $200 (2% of the account) with a 50-pip stop loss.
This is just an example to explain how position sizing works. Please note that you don’t have to keep your stop levels the same. You should adjust your position size according to your individual risk tolerance and trading strategy. However, you should know all these things—account size, risk per trade, and stop loss levels —when determining the appropriate position size in forex trading.
Even though you can do these calculations manually, it is best to use trading tools, which can deliver quick results of different values, such as position size, margin, profits, pips and more.
How To Calculate The Right Position Size?
Though we have explained how you can calculate position sizing in the above example, let’s take you through it in a more formal way. Here are the steps that you need to take to calculate the right position size.
1. Determine Your Account Size: The first step is to determine the size of your trading account. This is the amount of money you have available to trade with.
2. Determine Your Account Risk: After you have determined your account size, you need to decide how much of your account you are willing to risk on a single trade. The general rule of thumb is to risk no more than 1-2% of your account on any one trade.
3. Set Your Stop Level: You must determine where to place your stop loss order. This is the price level at which your trade will automatically be called off if the market moves against you. The number of pips you are risking is the difference between your entry price and your stop loss price.
4. Calculate the Ideal Position Size: You can now calculate the ideal position size based on the information you have gathered from the previous steps. To do this, you need to use a position size calculator, or you can use the above formula that we have discussed.
5. Adjust Your Position Size: Once you have calculated your ideal position size, you may need to adjust it based on other factors, such as the liquidity of the market, the size of your account, and the volatility of the currency pair you are trading.
If you follow these steps, you will have no problem finding the right position size for your trade. Therefore, give yourself proper time; this is an important part of risk management and can help you minimise your losses and maximise your profits.
Popular Position Sizing Strategies
So far, we have provided you with a traditional approach to finding the position size. There are, however, a few popular strategies that traders prefer to use to allocate the size of their positions in the market.
Before we take you through these strategies, you must test them beforehand on a demo trading. It is a must because a demo trading account offers you an environment similar to a live trading account. Even if you commit a mistake here, you won’t have to bear its cost as you would be trading with virtual money.
Fixed dollar value
- As the name says, traders allocate a fixed dollar amount to every trade that they make.
- The Fixed dollar value strategy is a simple way of implementing position sizing into your trading strategy and is great for traders who have just begun their journey as a trader or those who lack the necessary funds to trade.
- Since you are risking a fixed dollar value, this strategy greatly reduces the risk for traders.
Fixed lot sizes
- Traders implement this strategy using a fixed lot size, i.e. fixed micro-lots, fixed mini lots or fixed lots
- This is, again, the simplest position sizing method to go by. However, it doesn’t calculate the current risk, investment value, or volatility.
Fixed Risk Position Sizing
- Fixed risk position sizing is the most commonly used position sizing technique used by traders.
- Traders risk a small percentage of their overall capital on each trade.
- Depending on the financial instrument you’re trading, you should risk a maximum of 1% to 3% of your account on a trade.
- As a rule of thumb, you should not risk more than 2% of your account in one trade.
Contract Size Value
- This strategy is more often preferred by commodity traders.
- Traders start with small contract sizes and go up as they gain more market knowledge.
After you test these strategies on a demo account, you can apply them on a live trading account. But make sure you choose the same trading platform on which you tested your trading strategies. The choice of your trading platform depends on you. If you are a beginner, MT4 can be a good choice, or you can choose MT5, a trading platform with better trading features and the ability to allow trading of multiple assets.
In The End
Position sizing is a fundamental concept that all traders should know how to implement. In this article, we have explained position sizing with the help of examples. Based on your preference and availability, you can calculate the position size either with the help of a calculator or using the formula. Calculating the position size for your trade is a straightforward process. However, things get tricky when you have to adjust your position.
Therefore, ensure you reset the factors, such as stop losses, account size, etc., per your risks and goals. If you still don’t know where to start, we recommend starting with the popular position sizing strategies we have covered in this article.