Position Sizing


Introduction

As we've discovered traders are risk managers, so as such we should be able to calculate the correct position size as well as our total exposure.  As we've discussed in Managing Risk, we know not to risk over 2 % of our total capital, but how does this work in reality when entering trades?  The “amount at risk” is not the same as “used margin”. In fact, they are two very different things. The amount at risk is the amount you stand to lose if price hits your stop loss level (and hopefully you'll have one, a stop loss that is...). To understand more about margin, see the section in this module on Leverage and Margin.

Knowing the position size is vital, because if you get it wrong, your profits in pips may not be a profit in $/£/€'s.  All the technical analysis in the world will mean nothing if this isn't correct.  The trade setup must determine position size, NOT the other way around! This is one of the most critical aspects of retail forex trading.

The wrong Position Size

In the below chart we have two traders.  The first trader has followed the position size rules and risked no more than 2% of his capital, as highlighted in "Calculating Position Size" below - the second hasn't.  Both are trading EUR/USD mini contracts where a 1 pip (point) move equals $1. The system is a 66.6% winning system as highlighted by the "profit/loss in pips" column, but we can show the varying success of different traders depending on their position size.

Trade        Profit/Loss in PipsTrader 1. Mini EUR/USD Contracts$ Profit / LossTrader 2. Mini EUR/USD Contracts$ Profit / Loss
 11101011006660
 2701070010700
 3100101000121200
 48010800141400
 5-18010-180020-3600
 6-7010-70010-700
 Totals110
1100 -340

Because Trader 2 has been told it's a 66.6% winning system he gets carried away with himself, while Trader 1 is expecting slow steady gains.  In the end Trader 2 looses even though his winning trades have gained more pips than his loosing ones.

Calculating Forex Position Size

We need to know the info in the below table before we can calculate our FX position size.  I've put in some figures as an example. NOTE: This calculation only works when your account currency is the same as the currency pair's quote currency (the second of the pair - see "What's Forex, Reading Quotes & USD Index").

What We Need to Know FIRST!!!!    Example 
B.  Account equity or balance US$ 10,000 
Currency pair you are trading EUR/USD 
R.  The percent of your account you wish to risk 1% 
P1. Entry Price1.3500
P2. Stop/Loss Price. using our target and reward-to-risk ratio 1.3000 
T.  Long or Short Trade1 for Long, -1 for Short

Position Size = (R x B) / {T x (P1-P2)}

Let's assume we're trading long in EUR/USD.  Using the above data:

(1% x 10,000 = 100) / {1 x (1.3500 - 1.3000)} = 2000 units

Forex accounts come in standard, mini and micro lot accounts and are a representation of Trade Size in a different format. A Standard Lot would represent 100,000 of any currency at €/£/$10 per pip, whereas a Mini Lot represents 10,000 at €/£/$1 per pip and a Micro Lot represents 1,000 at €/£/$0.10 per pip. So essentially 1 standard lot = 10 Mini Lots  = 100 Micro Lots.

So from the above calculation you can trade:
2 micro lots (2000 units/1,000)
0.2 mini lots (2000 units/10,000)
0.02 standard lots (2000/100,000)
You would trade through a micro account in this instance as you need at least 1 micro, mini or standard lot to trade (usually)...

The below Forex Position size calculator is an easier way to calculate your positions:)

Forex Position Size Calculator


Calculating a Share, CFD, etc. Fixed Position Size

We use a similar formula for trading shares, indices, cfd's, etc...  To calculate position size we use formula:

Shares Position Size = {(R x B) - (commission)} / {T x (P1-P2)}

Let's look at an example.  Once again a trader has $,£,€10K in capital (not his/her leverage, but actual capital) and is prepared to risk 1% of his/her capital.  If the stock is $,£,€12 and stop loss of $,£,€11.90 suits his/her risk-reward-ratio and technical's, then the number of shares, cfd's, positions to trade is:

[{(1% x 10,000 = 100) - (1)} = 99 / {1 x (12 - 11.90 = 0.10)} = 0.10] = 990 shares

The method outlined above is typical of a method referred to as Fixed Fractional position sizing in which a certain percentage of the overall account balance is risked on each trade. The advantage of this trading method is that the amount you risk per trade is automatically adjusted as your trading capital fluctuates.

Our Online Position Size Calculator:

To calculate your position size if you like. NB. DON'T LOOK UP STOCK PRICE. IT GOES BLANK. Oh, there's no commission on it either.

Position Size


Position size and correlated markets

The position size taken should take into account ALL trades a trader is currently exposed to. For instance a trader who only risks 1% of his/her capital will make sure this 1% risk is spread over all open correlated trades. In other words you probably wouldn't risk 1% of your capital on Apple Inc and 1% on Microsoft Inc, as they're heavily correlated. See Managing market correlations to reduce risk in this module for more on this subject.

Calculating Position using Percent Volatility Method

The above position sizes are fixed over all markets, but as we know not all markets are the same.  How should we deal with this?  Well, you can continue taking a fixed position size, or adjust your position size in line with market volatility, using ATR as an indicator of calculate volatility.

For instance a  $/£/€ 100 per share position on a stock that on average fluctuates 5% per day, may in fact be a larger risk than a  <<<<<<< HEAD $/£/€ 150 per share position on a stock that fluctuates 2% per day.  So we need to look at all the factors putting the account at risk.

The Percent Volatility Method is a strategy to calculate position sizes in different markets with differing volatility.  Risk is now measured as a percentage of volatility.  Using this method a trader will take larger positions when volatility is low and vice-versa.

For example our trader who has a $/£/€ 10K, risking 1% ($/£/€100) will calculate his/her volatility position size in the following way.  Let's assume ATR (average true range) is 2 and he/she has already identified the stop and it fits in with his/her reward-risk-ratio.

{(R x B) - (commission)} / ATR    ====>   99 / 2 = 49 Shares/Units/Contracts

This 49 units position size must then be multiplied to the price per pip of your total stop/loss.  If the amount is under your 1% risk management figure then fine.  If it's over then maybe you need to think again, or maybe you believe it's worth it.


Other Position Size Techniques

There are many position size techniques out there.  One such technique is the Martingale/Anti-Martingale Strategy.  Basically the Martingale Strategy doubles up your position size per contract on every loosing trade and when you win you return to your original position.  

For example, if a trader's first position is 2 contracts and he looses, the next position will be 4 contracts.  If this looses his third position will be 8 contracts, but if this one wins then his fourth position will return to 2 contracts. I hope you can see that even if your strategy has consistently given 50% winning trades, you may go several trades without a win and your money may run out. It's like flipping a coin, even though there's a 50% chance of a head it doesn't mean that after you flip a tail a head will come next.  Each throw is independent of the last.  This strategy goes against the golden rule of trading - Let your profits run and cut your losses.

The Anti-Martingale Strategy increases your position as the trade goes for you, but not on a loosing trade.  It works the opposite way from the above paragraph

To Sum Up

Knowing how to set the correct position sizes is only a part of what it takes to become a pro at risk management.  The other part is discipline.  Stick to your stops and pre-determined risk comfort levels and you'll be sure to have enough after your losses to take advantage of profitable opportunities.  Whether you go for a fixed position size strategy based on a percentage of your capital or a volatility method really depends on the strategy you develop.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

======= $/£/€ 150 per share position on a stock that fluctuates 2% per day.  So we need to look at all the factors putting the account at risk.

The Percent Volatility Method is a strategy to calculate position sizes in different markets with differing volatility.  Risk is now measured as a percentage of volatility.  Using this method a trader will take larger positions when volatility is low and vice-versa.

For example our trader who has a $/£/€ 10K, risking 1% ($/£/€100) will calculate his/her volatility position size in the following way.  Let's assume ATR (average true range) is 2 and he/she has already identified the stop and it fits in with his/her reward-risk-ratio.

{(R x B) - (commission)} / ATR    ====>   99 / 2 = 49 Shares/Units/Contracts

This 49 units position size must then be multiplied to the price per pip of your total stop/loss.  If the amount is under your 1% risk management figure then fine.  If it's over then maybe you need to think again, or maybe you believe it's worth it.


Other Position Size Techniques

There are many position size techniques out there.  One such technique is the Martingale/Anti-Martingale Strategy.  Basically the Martingale Strategy doubles up your position size per contract on every loosing trade and when you win you return to your original position.  

For example, if a trader's first position is 2 contracts and he looses, the next position will be 4 contracts.  If this looses his third position will be 8 contracts, but if this one wins then his fourth position will return to 2 contracts. I hope you can see that even if your strategy has consistently given 50% winning trades, you may go several trades without a win and your money may run out. It's like flipping a coin, even though there's a 50% chance of a head it doesn't mean that after you flip a tail a head will come next.  Each throw is independent of the last.  This strategy goes against the golden rule of trading - Let your profits run and cut your losses.

The Anti-Martingale Strategy increases your position as the trade goes for you, but not on a loosing trade.  It works the opposite way from the above paragraph

To Sum Up

Knowing how to set the correct position sizes is only a part of what it takes to become a pro at risk management.  The other part is discipline.  Stick to your stops and pre-determined risk comfort levels and you'll be sure to have enough after your losses to take advantage of profitable opportunities.  Whether you go for a fixed position size strategy based on a percentage of your capital or a volatility method really depends on the strategy you develop.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.