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With the advent of the Internet, forex trading — which was once the exclusive domain of large banks, funds, corporations and high net worth individuals — is now available to just about anyone with an Internet connection and a small amount of money to trade with.
While the possibility of making large sums in the forex market exists due to the considerable leverage offered to traders by many online brokers, this feature of online forex trading could also be a recipe for disaster for novice traders unfamiliar with the significant risks involved in trading foreign currencies.
Trading strategically in the forex market typically involves a number of elements that should be thoroughly reviewed before an actual trade is made with any substantial amount of trading capital. The main element consists of developing and testing an objective trading plan, which ideally indicates when a trader should enter and exit the market, as well as the amount of risk the trader is willing to assume with each position.
The risk management aspect of a trading plan is where position sizing becomes very relevant to a forex trader interested in being in business for the long term, and that will be the focus of this article.
The Importance of Position Sizing in Forex Risk Management
Appropriate position sizing represents one of the most important components in the successful management of the funds deposited in a forex trading account. A suitable determination of the size of a trading position relative to the size of the trading account, the proportional risk incurred relative to the expected chances of the trade’s success, and the market risk given volatility levels are essential components of a sound trading plan. A proper money management and position sizing plan could prevent the trader’s account from becoming severely compromised by an unexpected adverse market move.
Strategically, proper position sizing in forex trading helps a trader lower the inherent risk involved in taking on a forex position in a fluctuating market. The amount of risk to be taken on each trade is a typical part of the money management aspect of a trading plan. A sound trading plan would ideally specify the position size of each trade according to some objective criteria the trader feels comfortable with.
Furthermore, a position sizing strategy becomes a vital element of a trade plan for a newer forex trader mainly because if they take too much risk when they begin trading, especially in a volatile market, the chances of their account’s survival could be significantly reduced before they can reap the benefits of an otherwise sound trading strategy.
The following sections will describe some of the more common position sizing strategies used by forex traders in greater detail.
Popular Forex Position Sizing Strategies Among Forex Traders
Forex traders generally have their own unique approaches to taking risk and can choose to follow any number of different position sizing methods that should be explained in detail as part of the overall strategy outlined in their trading plan.
For example, many traders will determine the size of their position according to the amount of money they wish to put at risk in their trading account. A seasoned trader will usually know exactly what percentage of their account is being put at risk with any given trade.
Furthermore, many professional traders will decrease their trading position size in risky volatile markets, or when they are having a losing spell. This can significantly reduce the overall risk and hence potential damage to their account balance.
A number of popular position sizing strategies are listed and explained below.
Fixed Lot Position Sizing
Also known as “fixed value” money management, fixed lot position sizing is perhaps the simplest of the popular money management models used for sizing trading positions. In this strategy, a fixed number of lots are designated for trading regardless of the balance in the account or how much the account fluctuates. For example, with an account of $10,000 U.S. Dollars, a trader might assign a standard position size of one whole lot per trade.
The principal advantage of this technique is in its overall simplicity. The strategy is easy to manage because of the consistent lot size, thereby allowing the account to increase arithmetically, or by a constant amount over a certain period of time, given favorable results. This strategy seems especially suitable for a trader that plans on withdrawing their profits on a monthly basis.
Nevertheless, a disadvantage of the fixed lot strategy is that it does not provide the trader with the ability to maintain a constant leverage as the account’s balance fluctuates. This can lead to larger and larger drawdowns in the account, which can become uncomfortable if the trader sustains a prolonged losing streak.
Fixed Fractional Position Sizing
Originally developed by Ralph Vince in his 1990 book “Portfolio Management Formulas”, the fixed fractional position sizing strategy typically defines the trade plan’s trading unit as a pre-set fraction of the equity present in the trading account.
This means that the risk taken on each trade is a known fraction or percentage of either the total amount in the trading account or the amount the trader wishes to use as trading capital.
Because the fixed fractional model is based on the number of traded units that represent the risk on the trade, the risk remains constant as a fraction of the equity in the account. The unit is reduced if the equity in the trading account is declining, while the units increase as the equity in the trading account grows.
The trade risk in this method is the capital amount the trader is willing to stomach represented by the level in which a protective stop is placed, giving a dollar amount to the risk involved. If stops are not employed, then the trade risk is calculated by the maximum drawdown or average loss, which can be considerable in the forex market on a busy day.
In theory, because the size of the trading unit stays proportional to the account size, the risk of total loss is zero. Nevertheless, in practice, especially in a market as volatile as the forex market can be from time to time, protective stop orders are subject to slippage and can be filled significantly away from the order’s price, which could in some cases even cause the account’s balance to be completely compromised. Therefore, it is always a good idea to use small fixed fractional risk percentages.
Another advantage of this sizing technique is its compounding effect on winning trades. As the account appreciates, the size of the trading unit is increased allowing for the geometric growth of the account. Furthermore, if the trader is going through a losing spell, this position sizing technique calls for the reduction of the trading unit, which minimizes the risk to the trader’s equity.
The disadvantage of this technique generally lies in its application with a small account balance. In accounts with lower equity balances, the lot unit tends to be too small to significantly increase the equity in the account sufficiently to justify the trader’s attention. In addition, the winning trades needed to increase the unit size require the trader to produce a high return. Also, reducing the size of trading units during a losing streak could make recovering from a large drawdown increasingly difficult once the trader’s luck turns.
Fixed Ratio Position Sizing
The fixed ratio position sizing strategy was first introduced by Ryan Jones in his book “The Trading Game”. In the fixed ratio position sizing model, the relationship between growth and risk are addressed, thereby giving the trader precise indications of when to increase or decrease their lot sizes.
Fixed ratio trading allows for the position size to increase or decrease as a function of the profit and loss in the account. Winning trades can be added to with more lots, while losing trades get reduced as the losses increase. This allows for the trader to increase the available margin in the account while decreasing the risk.
The technique is ideal for a small account size in that it takes advantage of consecutive winning trades. As the account increases during a winning streak, the trader can be more aggressive by trading larger position sizes. Conversely, if the market goes against the trader, the position size is decreased so that more conservative trades are taken. If their trading system continues to generate losses, the trader will eventually stop trading it at some point.
The main risk in this position sizing method consists of the potential drawdown on the position in its initial stages. If the position incurs a severe drawdown initially, the account could take a considerable blow to its balance. To make the technique work properly on the downside, the drawdown should not exceed an amount specified beforehand.
Fixed Risk Position Sizing
In a fixed risk position sizing method, a trader might determine the size for trades made in their account based on the risk of trading in a particular market as assessed by using a suitable risk measure such as volatility. In this method, they might take smaller positions in riskier higher volatility markets and larger positions in less risky, lower volatility markets.
Furthermore, with the fixed risk position sizing, the size of the trade is a function of the some measure of market risk, rather than account balance, so profits or losses do not show a consistent type of equity growth or loss.
The main advantage of this method is that it allows the trader to adjust their position sizes so that the risk initially taken on each position remains consistent based on recent market conditions. In volatile markets, this typically result in smaller position sizes that can help protect a portfolio from undesirable drawdowns in widely fluctuating markets. Nevertheless, larger positions can be taken in calmer markets, which can improve returns generated when trading such markets successfully.
The disadvantage of this type of position sizing is that risk measures can easily change significantly due to a market shock that occurs while a trading position is being held, and a method for dealing with this sort of shift needs to be planned for in the trade plan. Adjusting the position size may be appropriate in this situation.
For example, if volatility in a currency pair jumps up after an unexpected event, then the position size held in that currency pair can be reduced to bring the risk back in line with what was originally intended for the trade. Conversely, if a formerly volatile currency pair relaxes into a trading range, volatility will fall and the position size can be increased to account for the lower market risk.
This type of position sizing also lends itself to being combined with a fractional position sizing technique so that when the equity in the account rises due to profits that have been accumulated, the size of the risk weighted position increases proportionally. Conversely, when the equity in the account decreases, the risk weighted position size also declines.
Forex Position Size Calculator
As part of their preparation for starting to trade a trade plan, it typically makes sense for a trader to create a forex position sizing calculator if their plan calls for anything other than simple fixed lot position sizing.
This calculator will be used to calculate lot size for each trade and can usually easily be programmed into an Excel spreadsheet kept open on the computer used for trading. This will typically be a more reliable method than using a hand held calculator to determine the position size. Once the decision to trade has been made and the appropriate lot size has been calculated, the trade can then be executed in the market.
Additional Risk Considerations and Managing Risk with Stop Losses
Some additional common sense risk parameters seem worth mentioning and may be incorporated into the trade plan and position size calculator. For example, to be safe, a trader must be able to accept losing on any given trade and to be able to survive taking losses on ten consecutive trades. Since those ten consecutive losses should not exceed a total 25 percent drawdown, this means that no more than two percent of the portfolio should be put at risk on any particular trade.
Once the trader has figured out how much they are comfortable losing, a stop loss level for each trade should be determined and either placed in the market as an order or watched carefully. A seasoned trader will generally know where to put their stop loss orders after having optimized their trading plan, and chart analysis is often performed when setting stop loss levels.
Two rules of thumb should be observed when use stops to manage risk on forex positions:
- Never adjust the stop loss to arrive at a desired position size, but instead adjust the size of the position to meet your risk level and desired stop loss order placement based on your analysis.
- Trade using the same risk parameters on every trade regardless of the size of the trade varying due to the distance of the stop loss. Avoid putting more money at risk to use a wider stop, and avoid risking any less money on a stop closer to the trading level. Adjust your position to meet your predetermined risk parameters.
What Technique to Use
Due to the extreme volatility inherent in trading currencies, the selection of a suitable position sizing technique can be crucial to the success of a forex trader. The first and foremost consideration for position sizing and trading forex in general is to survive to trade another day, and that can only be done by managing risk appropriately. Success is secondary, since not being able to trade basically eliminates the possibility of being successful.
Depending on the position sizing method adopted, the trader must calculate lot size, risk parameters and/or the percentage of equity in the account for each trade. Each trader is different and everyone has their own approach for money management, some of which perform better than others over time and in different situations. A position sizing technique that works for one trader, does not necessarily work for another trader using a different trading strategy.
Sound money management techniques can help make an average trader become better, and a good trader become Great. For example, a trader that is only right half the time but gets out of losing trades before the loss becomes significant, and knows to rides winners to a substantial profit, would be leaps and bounds ahead of most others out there who trade with no clear plan of action whatsoever.