Risk management trading

Risk management: How to perform position sizing in forex and futures market

Risk is everywhere. When you drive to work every morning or you take a flight or you take a bus to a certain destination. There is this risk of mechanical failure. A house can be destroyed by natural disaster. A business can collapse. But we can manage them by taking precautionary measures. These risks can be reduced.

Before a plane or a vehicle is used for transportation purposes. There is need to cross-check the mechanical systems like the level of engine oil, brake oil, water in the radiator and other important factors to make sure the vehicle or plane is in a good condition to be used.

When you buy or build a house. It is safe to obtain insurance for the property in case of unforeseen circumstances like a natural disaster.

A business goal is to make profit and grow. But, what if the business is not generating profit. It will collapse at some point. To avoid this the business should always try to create value for people, do appropriate marketing and generate sales. Some profits should be retained or saved or invested for bad times like an economic recession.

What is risk management in trading?

Trading is not any different. You see a buy signal, you then buy. Instead of the price going up, it falls. If you don’t set a stop loss. Your account balance gets blown up because you ignored risk management.

What if, you did set a stop loss and price went against you. Your account balance won’t be blown up. You are given a chance to trade another day.

What if you were too sure of the trade. You became somewhat greedy. You did set a stop loss, but you risked 80% of your account by using a very high leverage. The trade goes against you. Your $1000 account becomes $200. Ouch! That will sting you so bad.

The way to manage your trading risks is by position sizing. This is the most important part of trading. Without it, you can loose all your capital.

What is position sizing?

Position sizing is the act of choosing an appropriate number of units of a financial instrument you want to buy or sell.

Position sizing in currency trading.

Currencies are traded in pairs. The base currency and the quote currency.

For example:

EUR/USD = The EUR is the base currency and the USD is the quote currency.

Currencies move in pips.

Pips are the smallest movement in currency pairs.

For currency pairs except JPY as quote currencies. Example EUR/USD, GBP/CHF, AUD/CAD
1 pip = 0.0001 of the quote currency

For EUR/USD, that will be 0.0001 USD

For currency pairs that JPY is the quote currency. Example USD/JPY, GBP/JPY, AUD/JPY
1 pip = 0.01 of the quote currency

For USD/JPY, that will be 0.01 JPY

To do an accurate position sizing in currency trading. You need 4 parameters.

  1. The account size
  2. The risk (%)
  3. The number of pips
  4. Value of pips

Here is the position sizing formula:

Position sizing =  (Account size × percentage risk) / (number of pips × value of pip)

Example:

You are trading EUR/USD with an account balance of $10,000. EUR/USD has a pip value of $10. Your stop loss is 25 pips from your entry. You plan to risk 2% of your account. What is your trading volume.

Solution

Position sizing = (10000 × 0.02) / (25 × 10)

                            = 0.8 micro lot or a lot size of 80,000 units

That means, if you are buying. You are to buy 80,000 EUR with USD. if you are shorting the market. You are to sell 80,000 EUR with USD.

Position sizing in stocks or futures.

Stocks and commodities are not like currencies that move in pips. Rather they move in ticks.

Ticks are the smallest movement in stocks and futures. Decimal places vary depending on the stock or futures you plan on trading.

To do an accurate position sizing in stocks or futures trading. You need 4 parameters.

  1. The account size
  2. The risk (%)
  3. The number of ticks
  4. Value of tick

Here is the position sizing formula:

Position sizing = (Account size × percentage risk) / (number of ticks × value of tick)

Example:

You are trading WTI crude oil with an account balance of $100,000. WTI crude oil has a tick value of $10. Your stop loss is 30 ticks from your entry. You plan to risk 1% of your account. What is your contract size?

Solution

Position sizing = (100,000 × 0.01) / (30 × 10)

                            = 0.33 micro lot or a contract size of 33,000 units

That means, if you are buying. You are to buy 33,000 barrels of WTI crude oil. if you are shorting the market. You are to sell 33,000 barrels of WTI crude oil.

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