Profit And Position Sizing: How They Work Together16.05.2015
Profit and position sizing is not limited to the Forex market. Anyone who is going to invest funds in any investment vessel such as stocks, mutual funds, commodities, bonds and anything else has to understand that position sizing is often the way to determine proper profit for an investment. You can think of position sizing as a risk management strategy.
Risk management is asking the question of how many lots are you going to buy or sell of a currency pair. Whether you ask this question subconsciously or not it is something that is in your mind. The problem is that many do it by pulling a number out of a hat, so to speak, which can lead to an improper formula with regards to profit. Position size must be a conscious choice where you follow a plan to ensure that position size is working for you in terms of gaining proper profit.
You cannot be inconsistent with the amount you trade each. Rules have to be in place so that you are not risking it all based on the feeling of luck. Each trade on currency pairs is going to have risk, but you need to decide what risk you take for a single trade as a way to compare it to the total capital you have. It is a more stable option than going with luck.
Risk exists in every trade you are going to make. Forex can have some higher risks for those who have never learned how currency pairs works. Once you know how the Forex market works and what you are truly trading, you can limit your risks to low, medium, and high risk positions based on short and long term investments.
Calculating Position Size
There is a position size calculation that you should know. This calculation is used to determine the stop loss and entry point on the currency pair ensuring you have set the trade for the maximum tolerable loss. This is an important point—trades can lose. You may have all the information available and even follow the majority group of investors and still have losses.
One way to account for these situations is to reduce the position size if you set your stop further out from the entry point. For the position sizing you need to know the following:
- How much money you have to trade on the pair
- What is the percentage of that money that you wish to risk
- What do you want the distance of entry price to stop loss to be for every trade you make
- What is the pip value on the currency pair being traded
If you have those answers you can use the following formula:
Position size=((account value x risk per trade)/pips risked)/pip value per standard lot
Think about a currency pair like the EUR/USD where you may wish to lose up to 2% of the investment. You decide an acceptable loss based on the currency pair is 25pips. You would then find the current pip value, which might be 1.35 Euro. You can plug the details in to the formula to find the position size.
You may want to start off creating five different trades with different position sizes based on the pips just to see how the formula works and what risk you feel most comfortable with.
Even if you have a micro account such as $1,000 to start with, you can still invest in Forex. You do not have to buy 10,000 units as a lot size if you have a micro account broker.
Now that you understand the risk management, risks, and need for a position sizing formula it is possible to look at how position size and profit relates. Obviously the formula helped you devise an acceptable loss point. You know how much you are willing to risk, so you also need to know how much profit you are willing to gain.
There is such a thing as staying in a currency pair or trade too long depending on the type of risk and investor you wish to be. Obviously you want to find as much profit as possible on every trade, but are you willing to lose what profit you have obtained just to wait and see if the position will move higher?
You have a stop loss in place that will sell if that pip value is met. This loss is below the entry point you make.
You can also set all sell commands one that will follow the pip value. For example what if you entered in on the EUR/USD at 1.35 and you saw it increase to 1.53 you could have your stop loss move with position. You might set the stop loss at .20. This means at 1.33 given the current 1.53 you would have a sell command. Should the currency pair fall to 1.33 suddenly you sell out. Now you only lost .02.
As the value of your trade increases so should your sell command rather than being at the original entry point. You may see the price increase up to 2.00 with a stop loss at 1.80. The profit from 1.80-1.35 is .45, which is your profit.
You could also go in at 2.00 and sell clearing the automatic command you have in place to obtain a profit of .65 instead. So now you have an idea of profit you just need to determine how much profit you want to make in terms of position sizing. If you have 1000 with a profit move of .65 that is smaller than 10,000 at .65; however, based on your risk needs you may want to start with a smaller profit until you have a larger portfolio that can handle the increase to profit.
In Forex you need a position size that you can live with based on your total capital available, where you can diversify and not put all your cash into one trade. But you also need a position that will offer a profit.
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