The Importance of “Position Sizing” in Forex Trading
Among the many questions we often receive are related to capital management and risk management in forex trading, one of which is, “How many pips should I put stop-loss ?” And usually we answer, “Adjust the capital and use support and resistance as a reference. “
There are at least two methods of determining stop loss. There is a technical stop based on support and resistance (or maybe also an ATR indicator ), there is also an equity stop based on the risk limit to capital. It is best to combine the two methods. From the merger of these two methods, position sizing was born.
What is “position sizing” ?
Simply stated, we can say that position sizing is about setting the right transaction volume in opening a buy or sell position in accordance with the risk limits in the trading plan . Knowledge of position sizing is part of capital management, which is one of the most important things a trader must possess.
Sorry, I am correct: it is not very important , but the MOST important, along with the knowledge of psychological analysis and mastery of course. Remember 3M: Mind, Method, Money ?
Remember that the job of a trader is basically “managing” the risk. That is why before you start trading, you must be able to calculate the amount of the transaction that you will do.
Actually finding how many lots to open per transaction is quite easy. All you need is simple numeracy skills plus some of this information:
– How much is your equity or balance ?
– What percentage of the risk limit have you set?
– What currency pair do you trade?
– How far is the technical stop-loss (in pips)?
If you have obtained this information, then you can tamper with the calculation.
How to calculate
Assume you have a balance of $ 10,000. You have determined that the risk per transaction that you can receive is only 5% of your latest capital, in this case it is $ 500 (5% x $ 10,000).
Now, the story is you will make a transaction on EUR / USD. Of course you have done technical analysis before and found that stop-loss should be placed 500 pips. Assuming quote 5 decimal places, where 1 pip = $ 1, then the amount of the stop-loss is $ 500.
Well, if your risk limit is only $ 500, then the maximum lot that you can install is only 1 lot. Calculation:
Thus, even if your transaction ends with a loss, then your loss does not exceed the risk limit that you have set.
Indirect currency pair
The previous calculation is if you make a transaction with the direct currency pair , that is the pair that has USD as the counter currency , such as EUR / USD, GBP / USD, AUD / USD and NZD / USD. All of these pairs, in the 5 decimal quote format have a pip value of $ 1 / pip.
Now, what if you trade in indirect currency pair , for example USD / JPY?
Actually the principle is the same, it’s just that you have to convert the pip value again into USD. For USD / JPY on FOREXimf, the quote is in three decimal places, so the pip value is 100 JPY.
To explain it, let’s just make an example.
For example, your last balance is $ 10,000. The risk limit per transaction is 5% or equal to $ 500. You have performed technical analysis in USD / JPY and opened BUY positions at USD / JPY at 120,000. You find that technically the stop-loss limit is 1000 pips, which is 119,000.
The question is: How many 1000 pips is USD?
Calm down … calm down. Here’s the explanation:
We already know that 1 pip in USD / JPY is worth 100 JPY. That is, a stop-loss of 1000 pips in USD / JPY is equal to 100,000 JPY (one hundred thousand yen). If later the price reaches the stop-loss level , which is 119,000, then 100,000 JPY will be worth around $ 840.34. Calculation:
Now, the amount of stop-loss in USD is already known. The next step is to calculate the maximum lot amount you can take.
Note: all calculations above DO NOT involve commissions and swaps (if any).
So we can conclude that risk management in forex trading is not only about where and how far stop-loss must be placed. More importantly, risk management must be accompanied by careful calculations that are adjusted to the strength of the capital you have. This is to prevent you from overtrading , aka opening too many positions which can actually endanger your capital.