Forex position size explained
Position size simply means to decide how many units or lots to use to buy or sell an instrument. The instruments could be of any asset class such as Forex pairs, commodities, stocks, cryptos, and so on. Traders have to decide how much to risk on each trading position and calculating the exact lot size can mean the difference between blowing up an account and growing it over time. Position size is often overlooked in trading as it does not seem as critical as win rate and risk-reward ratio, but it is a mistake. Proper position size can decide your trading performance. Imagine opening a 1 lot position in the Forex EUR/USD pair when you only have several hundred dollars in your trading account. A simple move of several pips can seriously damage your trading account which will be difficult to recover. If you lose 50% of your trading balance, you need to make 100% profits to recover it. To avoid these risks, you have to calculate trade size precisely according to your account balance, pip value, etc.
Critical components of position sizing
You can calculate trade size when you know the main components of position sizing. Here are the key components for position size calculation:
- Account balance - Lot size is directly calculated based on your account balance, to ensure you have enough money to cover the required margin and give the trade enough room.
- Risk percentage per trade - Many traders have a fixed risk percentage they risk per trade. It is generally accepted that traders should not risk more than 1-2% of their account balance, which is a very conservative and safe approach.
- Stop-loss distance - Position size also depends on your projected stop-loss distance in pips. If you have a small stop-loss distance at a few pips, then a bigger lot size might be appropriate.
- Win rate - If you have a lower win rate, you need to prepare for losing streaks, meaning you need to select a small lot size to ensure losses are not sharing your trading power.
- Risk-reward - How much you risk compared to potential profits is another crucial component of deciding the position size for your next trade.
Calculating the ideal size of the trade is a function of all the components described above and when a trader takes into account all the components, they can use an ideal position size and ensure capital preservation. Pip value heavily depends on your position size. For example, 1 lot EUR/USD means 1 pip movement is around 10 USD.
Why calculating the ideal size of trade matters
When the position size is too large, traders get exposed to many risks such as emotional trading, risk of ruin, and thinner chances of long-term survival. If you have 1 lot position on a 100-dollar account, then 10 pips adverse movement will blow up your trading account, meaning it is absolutely critical to select position size correctly. Another side effect of trading is emotional stress which will increase if you have large position sizes and some of them end up in losses.
Proper position size is a critical part of risk management in online financial trading. It is usually the main reason why professional traders avoid catastrophic drawdowns and preserve their capital in the longer term. A drawdown represents a decline from the peak equity (available money) and if left unchecked catastrophic losses might occur. Traders often risk a fixed percentage of account size per trade, but dynamic position sizing is also a valid strategy. Some methods allocate an optimal fraction of the trading account for each trading position. However, there is a difference between position sizing and account balance-based allocation of capital. For example, the Kelly criterion enables traders to calculate how much to risk on any single trade and is closely related to position sizing. The more capital you have, the larger positions you can take, and vice versa. This is important to both protect your capital when a string of losses occurs and grow your account when profitable trades occur.
Emotional trading often leads traders to use larger lot sizes after losses and more often than not they end up blowing up their accounts. Doubling down is a bad strategy in Forex trading and employing dynamic methods like the Kelly criterion is a much better option.
A disciplined approach is also very beneficial in the long run.
Common position-sizing mistakes
Here are the most common mistakes made by beginner traders when selecting their idea position size:
Over-leveraging
Using excessive leverage is a common mistake among beginner traders and it is also very costly. A small diverse movement can end up in a large loss when you use a large lot size not consistent with your account balance.
Ignoring pip value
Pip value varies by currency pair and lot size and trading the same lot size across different pairs without adjustment can result in more risks than the trader intended.
Skipping stop-loss
Proper position size is effective as long as the trader has a well-defined risk technique like stop-loss. Seasoned traders are especially well-versed in using effective risk management strategies like dynamic stop-loss placing and they often use trailing stops. The bottom line here is to always use stop-loss orders to ensure your position size is effective. If you calculate the position size correctly but allow losses to go twice your preferred size then you will damage your account and position size will lose its effectiveness.
Inconsistent risk limits
Changing risk percentage from trade to trade based on just feelings is a common mistake among novices, costing them lots of money. Erratic performance is what you need to eliminate from your trading and transform it into scientific and systematic.
The one effective method is to use a fixed fraction or percentage of your account. For example, not risking more than 2-3% on any single trade ensures your trading account stays intact in the long term.
Core formulas and step-by-step calculations
Ideal forex position sizing requires detailed calculations and knowledge of proper formulas. The simple formula looks like this:
Position Size (in lots) = (Account Balance × Risk %) ÷ (Stop-Loss in pips × Pip Value per lot)
By following this formula, beginners can develop a disciplined approach to risk management as they need to have exact numbers for their strategy defined.
This formula ensures that even if your stop-loss is hit, you only lose exactly the amount you wanted to risk and nothing more, which is absolutely critical in online financial trading.
What each term means:
- Account balance = Total amount of money in your trading account (for example 1,000 USD).
- Risk % = The percentage of your account you are willing to risk on every single trade (1% = 10 dollars).
- Stop-loss (in pips) = The distance in pips between your entry price and stop-loss placement price.
- Pip value per lot = The value of one pip for one standard lot.
Now that you know what each constituent part means, let’s discuss some practical examples of position size calculations.
How to calculate the size of a forex position
For example, if you have a 1,000 USD Forex trading account and a fixed risk percentage of 5% per trade (remember it is always better to go 2-3% per trade) maximum, and trade EUR/USD pair where 1 pip is around 10 dollars per lot traded (1 standard lot = 100,000 units), and your average stop-loss is placed 10 pips away, then the correct lot size would be:
1,000 * 5% / 10 * 10 = 50 / 100 = 0.5 lots
If you want to risk no more than 1% on each trade then the position size with the 1,000 dollar account and the same parameters as above would be:
Position size = 1,000 * 1% / 10 * 10 = 0.1 lots