Three Effective Position Sizing Methods For Trading Forex
Cory Mitchell, CMT
When trading foreign exchange (forex), position size is immensely important. With brokers offering 50:1 leverage, or even more in some countries, taking too big of a position size can wipe out an account in seconds if a big price move occurs. On the flip side, too small of a position size will leave the trader with much smaller returns than what is realistically possible.
Let's look at three position sizing methods. Pick one method and stick with it. Possibly, if utilizing a couple of very different strategies, you may see that one method may work better for one strategy, while another method works better for another strategy.
The full details of each method are outlined below, and each is covered briefly in the following video.
1% or 2% Risk Method
This is the most common position sizing method.
Pick the percentage of your account you are willing to risk on a trade. If starting out, pick 0.5%. If you have a good track record and a viable trading method, select 1%. If you are consistently profitable, then you could possibly go up to 1.5% or 2%.
If you pick 1%, on a $10,000 account you are willing to lose $100 per trade.
2% means your willing to lose $200 per trade, or $50 at 0.5%.
We will call this account risk.
For any given trade, we now need to figure out the position size so we attain our account risk. To do this, we need to assess how many pips we are risking on this particular trade. We call this trade risk.
Since volatility is constantly changing in forex, the number of pips we need to risk on a trade may vary from trade to trade, but our account risk doesn't!
For example, on one trade we may need 30 pips difference between our entry and stop loss (our trade risk), while on another we need 100, or 10, or 23 pips.
Once we know our account risk and trade risk we can calculate the proper position size.
Account Risk in $ / (Trade Risk x Pip Value) = Position Size in Lots
Pip value is something you know or need to lookup. If you have a USD account and the USD is the second currency listed in the pair, then you know the pip value is $0.10 for a micro lot, $1 for a mini lot, and $10 for a standard lot.
If you have an account denominated in another currency, if that currency is listed second in the pair, the pip values will be 0.10, 1, and 10 in your account currency for that pair.
For all other variations, it's best to find out what the pip value is using a pip value calculator. I use this one (not the broker, just the calculator). To figure out pip values on your own, see Calculating Pip Value in Different Forex Pairs.
Let's assume you have an $8,000 USD account and you buy the EURUSD at 1.1250. You place a stop loss at 1.1230 and are willing to risk 1% of your account.
Your account risk is $80 ($8,000 x 0.01).
Your trade risk is 20 pips (1.1250 - 1.1230).
The pip value is $0.10. This is for a micro lot. If you use this in the calculation, the position size it spits out will also be in micro lots.
$80 / (20 x 0.1) = 40 micro lots (or 4 mini lots)
Note that your leverage here is 5:1. You have an $8,000 account but are taking a $40,000 position.
Let's do one more.
Assume you have a $3,500 USD account and you short the USDJPY at 108.25. You place a stop loss at 109 and are willing to risk 1.5% of your account.
Your account risk is $52.50 ($3,500 x 0.015).
Your trade risk is 75 pips (109 - 108.25).
The pip value (use a calculator) is 0.092 for a micro lot.
$52.50 / (75 x 0.092) = 7.6 micro lots (round down to 7, or up to 8 micro lots if willing to risk slightly more than 1.5% of the account.
This is an excellent position sizing method, and one I recommend most people use. It works for nearly everyone.
The two methods below are more for specific types of traders.
Fixed Dollar Amount Position Sizing
The fixed dollar amount position sizing method is more for longer-term traders, or traders who are going to take a limited number of trades and are typically going to hold their trades for longer periods of time and have larger stop losses. You may or may not opt to use leverage.
Let's assume you want to hold forex trades for the long-term, yet you don't want to put all your capital into only one or two trades.
So you decide in advance how many trades you want to allocate your capital to. If you have a $100,000 you may decide to split it between 5, 6, 7, 8, 9, or 10 trades.
4 or 5 trades is enough. Once we start taking more than that, some of our trades are likely to be too heavily correlated and thus redundant.
Assume you have a $100,000 account for currency trading and are willing to split that up between 5 trades. That means you will put the equivalent of $20,000 into each trade.
You will then still choose a stop loss for each trade. For example, you may say that you will never let the currency pair go more than 5% offside (loss). Or 3%, or 2%.
5% of $20,000 means you are willing to take a maximum loss of $1,000 on any position. Note that even though in this case we are risking 5% on a trade (in the method above we only risked 1%) we are willing to risk more because we are only using a portion of our account for this trade. Notice that the $1,000 maximum loss is still only 1% of our total account balance of $100,000, in this example.
Adjusting for Trades and Leverage
If you find different trades that have big risk differences, you can apply more or less of the allocated amount to those trades.
For example, if you need to really only risk $500 on one trade, but need to risk $1000 on another (based on the $20,000 position size), you could allocate $40,000 to the $500 risk trade, thus bringing the risk up to $1000 (position size now doubled). Or if you only ever want to risk $500 per trade (2.5% of $20,000), you cut the $1000 risk position in half (now only $10,000 position), reducing the risk to $500.
In other words, 5 positions is your baseline for the account, but you can adjust this based on the risk of the trades you end up taking on.
Once you have decided how much capital to allocate to each trade, you could then decide if you want to use leverage. In this example, instead of putting $20,000 into 5 positions you could put $40,000 into each. This is means you are using 2:1 leverage. $60,000 into each is 3:1 leverage. Your risk increases accordingly, along with potential gains.
This position sizing strategy controls risk, but also allows for longer-term traders to give their trades more room. It also allows them to use no leverage, or pick the exact amount of leverage they want to use.
Tip: If holding trades for the long-term it is favorable to buy the higher interest currency in the pair in order to collect daily interest payments (instead of having to pay interest).
Maximum Drawdown Optimized Position Sizing
The maximum-drawdown-optimization sizing method can be used for strategies that are automated, non-subjective, or where the person has a multi-year history of trading the strategy.
Maximum drawdown, as it relates to this method, is the biggest number of pips the strategy lost before the account equity recovers.
For example, assume you have been trading a EURUSD strategy for the last two years. I look back at all trades and see that the worst period was a loss of 300 pips. You had other stretches where you lost 100 pips, 165 pips, and 275 pips, but losing 300 pips was the biggest drawdown period. This might have been the result of a rough period where we lost 10 trades in a row losing 30 pips on each, for example.
In other words, given the last two years of data, 300 pips was our maximum drawdown.
Then, increase this amount by 50% or 100%. If I have lots of data—hundreds of trades and the strategy has been tested or traded over at least three years—then I will increase the maximum drawdown by 50% to find out my position size.
If my maximum drawdown is coming from less data than above, I will typically assume that my drawdown could be double (100% more) what I have seen so far. The strategy should still be tested or traded on at least one year of data and should cover at least 100 trades at an absolute minimum. If you don't have that data, use one of the position sizing methods above.
Continuing with the example, we have a strategy with a maximum drawdown of 300 pips. We add 50% (in this case) so we assume the maximum drawdown could be 450 pips. If you have less data on a strategy, double the maximum drawdown: assume 600 pips is possible.
Now, you can look at your account equity to see what kind of position size you can take on every trade. [Note: this method works best with strategies where the amount of pips being risking is similar on every trade].
Factor Account Equity and The Most You Are Willing to Lose on Your Account
Assume you have a $10,000 account, and don't want to ever see your account drop more than 30%. In other orders, during a bad period you don't mind seeing your equity drop to $7,000, but no more, before it starts to recover. Of course, if your strategy doesn't have an edge, and you don't expect that your account will recover, don't use this method! You should know what you can expect from your strategy in terms of profits and losses.
You can make this maximum drawdown percent whatever you want 10%, 20%, etc.. The lower the drawdown used the smaller the position size and the smaller the return as well. Going larger than a 30% drawdown isn't recommended.
To calculate your position size, take the maximum you are willing to allow your account to drop by, which is $3,000 in this case (30% of $10,000).
Divide that by your maximum drawdown in pips (450 in this case) multiplied by pip value. In this case, we are dealing with the EURUSD so our micro lot pip value is $0.10, assuming a USD account.
$3,000 / (450 pips x $0.10) = 66 micro lots.
The nice thing is that you don't have to recalculate this as your account value changes. Assuming your maximum drawdown stays the same (a bigger one doesn't occur), you can just always use the same leverage! 66 micro lots is $66,000 which is 6.6x our $10,000 account.
If our account grows to $15,000 we can just multiply that by 6.6 to get $99,000. If we calculate it using the formula, it gives us $100,000. The 6.6x leverage method gives us a very good estimate of the proper position size.
Here's another example. I have a strategy in the GBPJPY which has lost up to 650 pips during a particularly rough period for the strategy. Rounding this up by 50%, I assume that it could actually lose 1,000 pips.
Assume you have a $20,000 account and don't want to risk more than 35% of your account.
35% of the account is $7,000. Assume a pip value of $0.092 per micro lot when using a USD account.
$7,000 / (1000 x $0.092) = 76 micro lots.
76 micro lots is 76,000 worth of currency. On a 20,000 account that is 3.8x leverage. That leverage ratio can be used to estimate the position size as the account value changes.
Apply the Method to Multiple Positions If They Aren't Correlated
Assuming you trade uncorrelated pairs or strategies, you can use this method for trading multiple pairs at the same time.
Only use this method on multiple trades at that same time if the trades and strategies are uncorrelated. If you take four trades using this method, and the trades are correlated, you could wipe out your account (assuming the unlikely scenario that you get maximum drawdowns in all at the same time).
BUT, if you trade different pairs or strategies that aren't correlated, and tend to take losses at different times, you can drop your drawdowns considerably!
Consider a scenario trading two different strategies or two different pairs. Both have maximum drawdowns of 30%, but these drawdowns occur at different times. That could mean that one strategy/pair is losing while the other is winning, offsetting the loss. You still get the profit from both strategies/pairs (maybe they make 40% per year each, with the leverage level used), but your risk is reduced because the pairs/strategies are uncorrelated. Your account still makes 80% but your account drawdown drops to 10%, for example, even though the strategies/pairs each have 30% drawdowns.
I do this with up to five positions (it's hard to find more than five pairs/strategies that aren't correlated)...but you need to always make sure that the pairs/strategies used to create these positions are uncorrelated. You also want to make sure that you aren't accidentally putting all your eggs in one basket by buying all risk-off currencies, or all risk-on currencies. Even though the pairs may seem uncorrelated at a given time, they may all move in the same direction under certain conditions. If you aren't sure what risk-on and risk-off are, learn what they are before using this method.
This method is for experienced traders who have a very good idea of how their strategies perform. They have a long history and hundreds of trades with the given strategy, providing them with a good basis for what the potential drawdown of the strategy is. The method can be used to increase returns while also offsetting drawdowns when using multiple uncorrelated pairs/strategies.
Final Word on Forex Position Sizing
Nearly everyone can use the 1% (0.5%, 2%, etc.) method. It's a great starting point, and many traders will never need anything else.
Longer-term traders could benefit from fixed dollar position sizing. This allows for the fine-tuning of leverage (or no leverage).
Experienced traders who know their maximum drawdown can really maximize their profitability and potentially even reduce their losses (with multiple uncorrelated strategies/trades) by using the maximum drawdown optimization method.
By Cory Mitchell, CMT. Join me on Twitter @corymitc.
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.