One of the most important elements of profitable forex trading consists of prudent money management. While it may not sound glamorous, knowing about forex position sizing could save you considerable amounts of money.
Including a position sizing method in your trading plan can buff your risk-management process to protect your trading account from significant losses, increase your flexibility and ability to adapt to changing market conditions, help you maintain a consistent level of risk-taking that reduces impulsiveness and over-emotional trade decision-making and boost your profits by ensuring you have enough capital to make winning trades as they arise.
Your forex trading plan should ideally include a sound method for trade position sizing to help improve your chances of success. In this article, Benzinga explains the importance of position sizing to currency traders, reviews various popular position sizing strategies and explains when using a forex position size calculator might make sense.
What is Position Sizing?
To currency traders, position sizing refers to the process of determining the appropriate amount of trading capital to allocate to each forex pair trade based on your trading strategy and risk-management goals. Position sizing plays a critical role in operating a sustainable currency trading business because the size of your positions can greatly impact your potential profits or losses.
In practice, position sizing involves calculating the ideal amount of a currency pair to buy or sell in each trade. Your position sizing decisions can be based on factors such as your account balance, the percentage of your account you are willing to risk per trade, the distance of your stop-loss order from your trade entry price and the volatility of the currency pair you are trading.
By determining the appropriate position size, you can manage your forex trading risk more effectively and avoid risking too much of your precious trading capital on any given trade. This can help you stay in the game for the long term and boost your chances of success as a forex trader.
Calculating Position Sizing
Various well-established ways of calculating a suitable position size for your trading account exist. These techniques include the fixed lot size, percentage risk and the Kelly criterion methods.
Currency traders can use one or a combination of these popular position sizing methods depending on their individual trading styles and goals. Each of these three popular methods is explained further below.
The Fixed Lot Size Method
This easy-to-use position sizing method involves setting a stable amount of currency you want to buy or sell in each trade. When using this technique, your transaction amount remains constant regardless of the size of your account or the risk involved in each trade.
For example, you may decide to trade in a fixed lot size of one lot of a currency pair that is equivalent to 100,000 base currency units. This means you will buy or sell one lot of a currency pair when you make each trade in your account.
The Fixed Fractional Method
Using a fixed fractional position sizing method means you will allocate a certain percentage of your trading account balance to each trade. This percentage will depend on the level of risk you are willing to take.
For example, you may choose to allocate a fixed fraction of 10% of your account balance size of $10,000 to each trade. The equation used to calculate position sizes determined using the fixed fractional method is:
Position Size = (Account Balance x Risk Percentage)
= ($10,000 x 10% or 0.10)= $1,000
=1 micro lot per trade
This position-sizing method ensures that your transaction amounts are a stable proportion of your account size. It also helps you avoid over-committing your trading account to any one position.
The Percentage Risk Method
This more sophisticated position-sizing method requires you to calculate your position size based on a fixed percentage of your account balance that you are willing to risk on each trade. This means you will determine your position size based on the distance of your trade entry level to your stop-loss level, which is typically expressed in pips.
You will also use the value of one pip for the currency pair you are trading in this position-sizing calculation. This so-called pip value will depend on the currency pair and the size of your position.
You can use the following formula to calculate position size using the percentage risk method:
Position Size = (Account Balance x Risk Percentage) / (Stop Loss Distance x Pip Value)
Using this method, a retail forex trader who has an account balance of $5,000 and is willing to risk a fixed percentage of 1% of their account on each trade will have a risk per trade of $5,000 x 1% or $50. If they wanted to take a trade with a stop-loss distance of 50 pips in a currency pair with a pip value of $10, then their computed position size would be:
Position Size = ($5,000 x 1% or 0.01)/(50 pips x $10)
= 0.1 lots x $100,000/lot = $10,000
= 1 mini lot
The trader would size their positions by buying or selling one mini lot of the currency pair.
The Kelly Criterion Method
The Kelly criterion is a mathematical formula for sizing bets that can be used by forex traders performing position sizing to determine the theoretically ideal percentage of their capital to risk on a particular trade. Forex traders can use the Kelly criterion calculation to determine an appropriate position size based on their risk management plan and the probability of success of a particular trade.
Because using the full trade amount suggested by the Kelly criterion may be too large for many forex traders’ risk appetites, they may instead prefer to use a fraction of the optimal Kelly amount to determine their position sizes.
Inputs to the Kelly formula include the trader's account balance, their trading strategy’s winning and losing probabilities based on its historical results and the proposed trade’s anticipated payout ratio. A fractional multiplier can also be included if desired.
The Kelly formula used to compute a trader's optimal account percentage to risk is as follows:
Optimal Account Percent to Risk = Winning probability - Losing probability/payout ratio
Based on that equation, if a trader’s strategy has a 70% historical chance of winning, a 30% chance of losing and a trade payout ratio of 3-to-1, then the resulting Kelly formula calculation would be:
Optimal Account Percent to Risk = 0.7 - 0.3 / 3 = 0.6 or 60%
This means a forex trader using the Kelly criterion position sizing method could risk 60% of their capital on this particular trade to achieve the optimal risk/reward ratio, although many traders would only feel comfortable using a fraction of that amount. Keep in mind that this position-sizing method assumes a trading strategy’s historical success rate will continue to prevail when that assumption may not be accurate.
While forex traders can use the Kelly criterion or a fractional Kelly criterion as a general position sizing guide because it may have benefits over other methods, it should not be relied on blindly, especially if changing market conditions might affect the future results of a trader’s strategy.
Strategies for Effective Forex Position Sizing
Various effective strategies exist for sizing positions when trading currencies. Appropriate position sizing is crucial in forex trading because it can significantly impact your profitability and risk management success. Some position-sizing strategy tips include:
- Have a risk-management strategy: Always use proper risk-management techniques when you trade. These might include setting stop-loss orders, taking profits promptly and diversifying your portfolio of currency pairs. Your position size should also reflect the level of risk you are willing to take on each trade.
- Size positions based on account balance: This can mean sizing positions by allocating a certain percentage of your trading account balance to each trade depending on the level of risk you are willing to take. This helps you keep position sizes proportional to your account size and avoid over-committing to any one trade.
- Assess volatility and market risk: The level of volatility in the forex market can affect your position sizing. High-volatility pairs might require reducing your position sizes to keep your risk manageable, while low volatility may require larger positions. This means you may need to monitor market conditions and adjust your position sizing accordingly, especially if you plan on trading more than one currency pair.
- Create and stick to your trading plan: Having a well-defined trading plan can help you determine the appropriate position size for each trade. A trading plan includes how you determine trade entry and exit points, where you place your stop-loss levels and what sort of expected risk-to-reward ratio you will consider to make a trade.
- Use a position-sizing calculator: Various online position-sizing calculators can help you determine the ideal position size for your trade based on your risk-management strategy and trading plan. Using such calculators helps you avoid making mathematical errors and allows you to make quick adjustments as market conditions shift.
- Avoid using excessive leverage: Using leverage wisely makes sense when sizing positions strategically. Traders should consider their risk-management plan and determine the appropriate level of leverage to use based on their trading strategy and risk tolerance. To limit your risk exposure and maintain a healthy trading account balance you may want to keep your leverage ratio to less than 20-to-1 and only use leverage when necessary to achieve your desired risk-to-reward ratio. You also need to keep track of your broker’s margin requirements and avoid overtrading.
Using the above strategies for effective forex position sizing can help you minimize your risk and maximize your profits while trading in the foreign exchange market.
Benefits of Proper Forex Position Sizing
Proper forex position sizing has various benefits and remains one of the key components of risk management that is crucial for long-term profitability. By using the appropriate position-sizing strategy, forex traders can keep their risk to acceptable levels, boost their profits, reduce their emotional involvement and have more control over their trading results. Here are some ways proper forex position sizing can benefit traders.
Increased Profitability
Using proper forex position sizing can lead to increased profitability in trading. It can also help you compound your profits over time. If you avoid risking too much capital on any given trade, then you can use the profits from successful trades to increase your position size gradually. This can lead to an exponential growth of your trading account over time. Appropriate position-sizing strategies can also help you maximize your profits on successful trades while minimizing your losses on losing trades. This means you can take advantage of market opportunities and increase your overall profitability, while still keeping your trading risk under control.
Better Risk Management
Appropriate position sizing means you can manage your risk more effectively. By keeping the amount of capital you risk on each trade to levels suitable for your risk tolerance, you can avoid large losses that could potentially demoralize you and wipe out your trading account. This allows you to remain more confident and stay in the game to take advantage of more trading opportunities down the road that can lead to increased profitability over time. By determining the appropriate position size based on your risk management plan, you also can minimize your losses and protect your trading capital. This can help improve your trading outcomes because you are less likely to blow up your account on a single trade or series of trades.
Reduced Emotional Trading
Proper position sizing can also help improve your trading psychology. When you use a position size that is appropriate for your risk-management plan, you can trade with more confidence and reduce the negative impact of certain emotion-related trading issues on your account balance. This leads to more consistent trading and more rational trade decision-making that can ultimately increase your profitability.
Greater Control Over Trading Outcomes
Using sound risk-management principles and appropriate position-sizing techniques lets currency traders can take control of their trading outcomes and helps them achieve better long-term success in the forex market. Suitable forex position sizing gives you greater control over your trading outcomes by allowing you to manage risk effectively, adapt to changing market conditions, trade more consistently, make more informed and rational trading decisions, cultivate more discipline to stick to your trading plan and improve your overall trading psychology and confidence level.
Common Mistakes in Position Sizing
Various common position-sizing mistakes occur that can lead to significant losses and decreased profitability for forex traders. To avoid most of them, currency traders need to stick to their trading plan and risk-management strategy, use appropriate position sizing methods, avoid emotional trading decisions and refrain from overtrading.
By remaining aware of these pitfalls, forex traders can increase their profitability and achieve long-term success in the forex market. Some of the more common position-sizing mistakes forex traders make include:
Overtrading
Overtrading is a common forex position-sizing mistake that can lead to significant losses and decreased profitability. Overtrading occurs when a trader opens too many positions or uses a position size that is too large relative to their account balance. Overtrading can arise because of emotional involvement in the trading process, a lack of discipline, misunderstanding diversification and underestimating risk.
Underestimating Risk
Underestimating risk is another common position-sizing error forex traders make that can lead to poor results. This mistake occurs when a trader does not properly assess the risks involved in a trade or calculates their position size based on inaccurate or incomplete information. This can arise because of a lack of analysis, overconfidence, an inaccurate assessment of the risks involved and a failure to adjust position sizes based on shifting market conditions.
Not Adjusting Position Size for Changing Market Conditions
Not adjusting your position size when market conditions shift is a common mistake forex traders make. It occurs when a trader uses the same position size for all currency pairs and all market conditions. Traders instead need to monitor forex market conditions and adjust their position sizes based on their risk-management plan and the present level of volatility. This helps them avoid exceeding their acceptable risk threshold and increase their chances of trading profitably.
Should You Incorporate Position Sizing into Your Trading Plan?
Incorporating a sound position-sizing technique into your trading plan will make good sense for most forex traders because it helps you limit your risk exposure and maximize your profits while allowing you to maintain a healthy trading account balance and remain flexible enough to operate under shifting market conditions.
Strategic position sizing is so important that many traders consider it an essential element for achieving long-term success operating in the forex market. If you plan on trading forex as a business, you should consider including a sensible position-sizing method in your trading plan as part of your overall risk- and money-management strategy.
Frequently Asked Questions
How do you calculate position size in forex trading?
How you calculate position size in forex trading depends on the position-sizing method you select. Many traders use inputs like their risk tolerance, stop-loss level and account balance to calculate an appropriate position size based on their risk-management plan and desired risk/reward ratio. They may then adjust their position size based on current market conditions and changing trends to maintain an acceptable risk threshold and a healthy trading account balance.
What is the proper position size in trading?
The proper position size in forex trading depends on your preferred position sizing method, but it should limit your risk exposure and prevent significant losses while allowing you to maximize your profits. Many traders size their positions based on their account balance, risk-management plan, risk tolerance and desired risk-to-reward ratio.
Is position size the same as lot size in forex?
No. In forex trading, position size and lot size are related but not the same. Position size refers to the total amount you control when you make a forex trade, while lot size refers to the standardized trading volume for a currency pair that is usually equal to 100,000 base currency units.