Now that we’ve learnt the painful lesson of trading too big, let’s look at how to use leverage effectively with proper “position sizing.”
The correct amount of units to purchase or sell a currency pair is determined by position sizing.
It is one of the most important talents in a forex trader’s arsenal.
We’ll go ahead and call it THE most vital ability.
First and foremost, traders are “risk managers,” thus before you start trading real money, you should be able to calculate position size in your sleep!
Now, before we can get our math on, we need five pieces of information:
- Account equity or balance
- Currency pair you are trading
- The percent of your account you wish to risk
- Stop loss in pips
- Conversion currency pair exchange rates
As is customary, we’ll explain everything with an example to make it easier for you to understand.
Newbie Ned here.
He blew out his account a long time ago, when he was much more of a beginner than he is today, because he placed on some massive positions.
He traded from the hip like a gun-slinging cowboy from the Midwest, and he traded BIG.
Ned didn’t completely grasp the significance of position sizing, and his account paid the price.
He re-enrolled in the School of Pipsology to ensure that he properly comprehends it this time, and to ensure that what happened to him never occurs to you!
In the examples below, we’ll show you how to calculate your position size based on your account size and risk tolerance.
The amount of your position will also be determined by whether your account denomination is the same as the base or quote currency.
If your account denomination is the same as the counter currency
Ned, a new trader, has just placed USD 5,000 into his trading account and is eager to resume trading. Assume he now employs a swing trading method that trades EUR/USD and risks approximately 200 pips every trade.
He has promised that he will not risk more than 1% of his account per trade since blowing up his first account.
Let’s calculate how large his position size needs to be to be inside his risk tolerance.
We can calculate the dollar amount risked by using his account balance and the percentage amount he wishes to risk.
USD 5,000 multiplied by 1% (or 0.01) equals USD 50.
The value per pip is then calculated by dividing the amount risked by the stop.
(USD 50) divided by (200 pips) equals USD 0.25 per pip.
Finally, we multiply the value per pip by a known EUR/USD unit/pip value ratio. In this example, each pip move is worth USD 1 with 10k units (or one mini lot).
USD 0.25 per pip * [(10,000 EUR/USD units)/(USD 1 per pip)] = 2,500 EUR/USD units.
So, to maintain inside his risk tolerance with his present trade setup, Newbie Ned should put on 2,500 units of EUR/USD or fewer. Otherwise, he’d be reverting to his former gambling nature.
Isn’t it simple?
What if your account currency is the same as the base currency?
If your account denomination is the same as the base currency
Assume Ned is now in the eurozone and decides to trade forex with a local broker, depositing EUR 5,000.
Using the identical trade example as previously (trading EUR/USD with a 200 pip stop), what size position would he take if he just risked 1% of his account?
5,000 EUR * 1% (or 0.01) = 50 EUR
Because the value of a currency pair is calculated by the counter currency, we must now convert this to USD. Assume the current exchange rate for one euro is $1.5000 (EUR/USD = 1.5000).
To calculate the value in USD, just invert the current EUR/USD conversion rate and multiply by the number of euros we wish to risk.
(USD 1.5000/EUR 1.0000) * EUR 50 is around USD 75.00
Following that, divide your risk in USD by your stop loss in pips:
(USD 75.00)/(200 pips) equals $0.375 per pip.
This provides Ned with the “value per pip” move with a 200 pip stop to stay inside his risk tolerance threshold.
Finally, multiply the value per pip move by the previously determined unit-to-pip value ratio:
(USD 0.375 per pip) * [(10,000 EUR/USD units)/(USD1 per pip)] = 3,750 EUR/USD units
So, in order to risk EUR 50 or less on a 200 pip stop on EUR/USD, Ned’s position size cannot exceed 3,750 units.
Isn’t it still pretty simple?
Now things get a little more complex.
