What is anchoring in trading? How does it affect trading? How to avoid anchoring bias and make a profit in trading? Read more about anchoring on the FX2 blog.
Risk management is an important aspect while trading the financial markets. While most focus is usually on entry levels, the focus should always be on the risk and how to keep it low. It’s the only way to ensure a trading account is not wiped out with one trade. Therefore, professional and experienced traders pay closer watch to position sizing than anything else before opening a trade.
Trade size position in forex refers to the number of units of an instrument one buys or sells. In the stock markets, people buy a given number of shares, which reflects the risk they take. In the derivatives markets, traders open buy and sell positions based on a given number of units of an instrument.
The position size or units is determined by the number of lots one buys or sells. There are three types of size lots in forex trading.
The number of units or position size used in forex trading comes down to several factors. For starters, it depends on the amount of capital in the trading account. For example, with $100 in an account, it might be difficult to buy or sell using a standard lot, given the high margin requirements that come with it.
In addition to capital, the amount of risk one can tolerate on any given trade is vital and influences position sizing. Trading with much smaller position sizes is crucial for anyone looking for low-risk exposure. Traders deploying aggressive trading strategies and willing to tolerate a much higher risk can opt for a higher position size.
Regardless of the trading strategy, position sizing is crucial as it can greatly affect the number of profits one generates and losses incurred when things go south.
The most important step to determining the position size in forex trading entails setting the percentage or dollar amount to risk in every trade or position. It is common to find traders settling a 1% limit risk on each trade. In this case, it means a trader would be risking $100 per trade in a $10,000 trading account and $10 in a $1000 trading account. If the risk limit per trade is 0.5%, it means the trader would be risking a maximum of $50 a trade on a $10,000 account and $5 on a 1000 account.
Therefore, the risk limit will always depend on the amount of money in the trading account and the percentage limit. Regardless of other variables changing, the risk should always be kept constant on every trade if one is to have a long career in trading.
Once the risk limit on an account is set, the next step is determining the number of pips that one is to risk on each position as part of the position size process. The Pip risk is calculated based on the entry point and the point where one wishes to place the stop loss order.
The pip is usually the smallest point of a currency price that changes. For instance, if the exchange rate of EUR/USD is 1.1234 and it increases to 1.1246, the smallest pip change is calculated by subtracting the last two-digit number from the two exchanges; therefore, 46-34 gives a 12-pip change.
On the other hand, stop loss order is the level at which a trader wishes to close a position should the trade go against them, resulting in losses. It offers a way of keeping losses low.
For instance, if a trader was to open a buy position on EUR/USD at 1.1234, the stop loss can be placed at 1,1220, implying the trader is risking 14 pips. If the profit target is 1.1246, it means the trader is risking 14 pips to Gain 12 pips as profit.
The pip risk, or the level at which traders place stop losses, often depends on how volatile a security or instrument traded is. In some cases, one may have a small pip risk and, in some cases, resort to a much bigger pip risk.
The pip value varies depending on the size of lots used to trade and the currency pair being traded. For starters, currency pairs with the US dollar acting as the second currency or quote currency, i.e., EUR/USD and GBP/USD have fixed pip values. Consequently, each pip on a micro lot will always have a value of $0.10. on the other hand, every pip in a mini lot will always have a value of $1.
Therefore, if EUR/USD is trading at 1.1234 and a stop loss is placed at 1.1220, it means the trader is risking 14 pips. If they open a micro lot, it means they stand to lose $1.4 (14 x0.10) on price doping to the stop loss order. On the other hand, if the profit target is at 1.1246, it means they hope to gain 12 pips on the trader amounting to a profit of (12 x0.1) $1.2.
If someone trades a currency pair that does not have a USD component, they will have to multiply the pip values by the exchange rate of the dollar and the quoted currency.
Consider someone who triggers a buy position on EUR/GBP at 0.8845, and places stop loss at 0.8830 and profit taking at 0.8870. It means they are risking 15 pips to gain 25 pips in profit.
If the GBP/USD rate is 1.2234, The 14-pip value for the stop loss will be $0.10 x 1.2234 for micro lots and 1 x 1.2234 for mini lots.
Once all the risk limits, pip risk, and pip value are determined, it becomes much easier to determine the position size that one should resort to while trading.
The ideal position size will always be
Pips at risk x Pip value x Lots traded = Amount at risk
Let’s assume someone has $5,000 in a trading account and doesn’t wish to risk more than 1% on a trade. The maximum amount of risk on each trade will be $50.
Similarly, if they are trading EURUSD and open a buy position at 1.2346 and place a stop loss at 1.12336, they risk 10 pips (pips at risk). If they are trading in min lots, each pip movement will be worth $1 (pip value). Therefore, the lots traded will be:
Pips a risk x Pip value x lots traded = amount at risk = 10 x $1 x lots traded = $50
Lots traded = $50/$10= 5 lots
While trading with mini lots, 5 lots translate to 50,000 units (5 x 10,000)
This means that the trader should place a trade with a position size of 50,000 units or less on the EURUSD to stay within their risk parameters.
While trading the financial markets, it is vital to understand and manage the risk. When determining the position, always consider how much you can afford to lose based on the underlying capital. Trading in small amounts with a proper risk management strategy is the only way to keep losses low and improve the chances of accumulating significant profits over time.