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AB12 - Position Sizing Explained

"Position sizing is something you will come across when you start to trade. Position sizing is a type of risk management that is used by traders. It is important that traders understand the importance of position sizing. It will help to preserve your trading capital longer and gives you more chances at trading. Most importantly, position sizing will stop your account from getting liquidated or blown by on a bad trading decision. Position sizing is not keenly followed by many traders. They only realize the importance of position sizing after they have lost their entire trading capital. Therefore, do not make this commonly repeated mistake many other beginners in forex trading do. In this article, we explain what position sizing is all about and how you can use this rather simple method to protect your account equity but also give yourself the chance to make consistent profits. Risk management in trading is just as important as your trading strategy so both position sizing and trading strategy go hand in hand."

If you have looked around at some forums, you will find traders asking or talking about position sizing. The term might seem a bit off from the usual. However, position sizing is very simple.

Position sizing is defined as managing the size of the position that you take in the markets. It is measured in lots, which represents the number of contracts or currency units that you trade. Position sizing has nothing to do with the size of your trading account. It is mostly focused on the position that you take in the markets.

Position sizing goes hand in hand with risk management. Understanding the rules of risk management will basically dictate how you should be using position sizing. This of course is based upon your total account equity.

As you can notice all these are interlinked. Starting with the amount of capital you have available to trade, accounting for the leverage that you will use, you can combine these with risk management principles to derive at an ideal position size.

The number of contracts or currency units that you trade will be determined by how risk averse you are.

To illustrate this with a simple example, let’s say you have funded your account with $10,000. The basic rule of risk management is that you should not be risking more than 1% on a single trade.

In dollar value this means that you should not be risking more than $100 on trade. Now there are different ways you can achieve this. We reiterate that when we mention risk of $100, it means that this is the maximum loss you will allocate to your trade.

A $100 loss can be interpreted as 10 pips if you trade a standard lot size of 100,000 contracts. At the same time, it can be 100 pips, if you trade with a mini-lot size of 10,000 units. And it can be 1000 pips if you are trading with a micro-lot which is 1000 units.

Thus, depending on the contract size or the lot size, we now know that you can:

  1. Set a stop loss of 10 pips when you trade 1 lot
  2. Set a stop loss of 100 pips when you trade 0.1 lot
  3. Set a stop loss of 1000 pips when you trade 0.01 lots

If you thought that position sizing was all about how many lots you can trade, there is more. It can get a bit more complex from here on.

Let’s say that you have analyzed the markets and you set your stop loss to just 50 pips. What this means is that you can trade 0.2 lots. By splitting your trades into two 0.1 lot trades you now have the flexibility to set different take profit levels.

Alternately, you can just enter 0.2 lots and then set the first target level where you will exit with half the profits and set a second take profit level where you will exit with the remaining portion on your trade.
Using these strategies, you can easily manage your risk. Many traders fail to follow risk management guidelines. This occurs due to greed of course. Traders focus more on making huge profits that they often ignore the basics of position sizing.

Position sizing is important mainly because it limits your risk or exposure on a trade by trade basis. This automatically increases your chances of still being able to trade despite taking losses.

One of the crucial things about position management is that you should also account for the profits. If you risk 1% of your capital but expect only 1% in profit, you could end up back to square one right after two back to back losses.

On the contrary, if you look for trading set ups that offer you a 1:2 or 1:3 risk/reward ratio can allow you to apply position sizing and also build up your equity at the same time.

There is a fine balance between position sizing where your risk is being defined and the trading strategy. Do not expect to become a master of position right away. You need to follow the rules and most importantly be disciplined in order to have position sizing and other risk management methods work for you.

The bottom line is that with position sizing, you won’t have the risk of blowing up your trading account on just one bad trade. This is essential because in forex, consistency at making profits is much more important than making big profits every now and then but also having to take on more risk.

Read 967 times Last modified on Saturday, 15 June 2019 11:54