By Rob Colville on December 9, 2016 in
We traders tend to fixate so much on ensuring accurate analysis that important factors like choosing a proper position size tend to get overlooked. Yet position size is critical to long-term trading success, and is directly related to how well (or poorly) we manage the application of risk in the markets.
Most commonly, traders in any market are advised to risk no more than 1-2% of their overall trading account on any given trade, but there are alternate theories out there. And because forex trades are measured in pips, not dollars, choosing a risk-minded position size translates directly into how many standard lots, or mini lots, or perhaps even micro lots the trader should buy or sell to participate in the market without being overly susceptible to a large drawdown.
What follows is a candid discussion about position size, why we favor the standard, 1-2% rule, and when, if ever, traders should differ from it.
It’s generally accepted across a host of markets that 1-2% is the “standard” position size, and we Lazy Traders happen to subscribe to that theory as well. New or conservative traders are often advised to risk 1% or less of their total account balance on any given trade, while more experienced traders and/or those with a higher risk tolerance can go as high as 2%. Here’s how position size may be calculated for forex:
Account risk (in dollars) / (Trade Risk (in pips) x Pip value*) = Position size (in lots)
*For USD-based accounts, pip values are: $.10 (micro lot), $1 (mini lot), and $10 (standard lot)
For example, a trader with a $5000 account size risking 1% on a EURUSD position with 25 pips between the entry and stop loss could buy or sell ($5000 x 1%) / (25 x $1) 2 mini lots or ($5000 x 1%) / (25 x $.01) 20 micro lots, which, of course, are the same thing.
Here’s why 1-2% represents a good position size:
Risk-aversion: Even good traders and proven trading strategies lose from time to time, and sometimes multiple trades in a row. A modest 1-2% position size helps ensure that even if you lost 5 or 10 consecutive trades—which would be unlikely, but possible nonetheless—the resulting account damage would be recoverable in rather short order. In the event of a 5-10% position size, however, the same couldn’t be said, and all or a majority of the trading account would be wiped out.
Diversification: Position size is also a means for preventing overexposure to any one particular asset or currency pair, since it stands to reason that most traders routinely have multiple positions open at one time. Observing the 1-2% rule maintains a larger cash component and prevents large segments of your portfolio from being tied up in one asset in the event that a geopolitical event or sudden policy change from a central bank causes a steep decline. It’s happened before, afterall!
Under “normal” trading conditions, it’s said that the “standard” position size is perfectly acceptable. So with that, when volume and volatility are not spiking in one direction or the other, and in the absence of major news like additional QE or central bank intervention, a new geopolitical event, or a spike in oil and/or equity markets, a 1-2% position size should be fine.
If, however, the markets are in a heightened stage of risk, perhaps 1% traders should move down to .5%, and aggressive, 2% traders should adjust their position size to 1%. Here are some instances where that may be the case:
Low-volume, low-volatility conditions: In the “summer doldrums” of July and August, and to a lesser degree, in late-December around the holidays, when traders and investors are on the sidelines, price action tends to slow to a dull crawl, and with volume and volatility low, it can be harder to exit a position quickly, if need be, which often warrants a smaller position size.
In times of market and/or economic turmoil: Conversely, when volatility spikes higher in response to unexpected market events like a military conflict, banking or financial scandal, or flare-up in the Eurozone debt crisis, many traders will revert back to trading half their normal position size to better control their risk exposure.
On the heels of a large drawdown or losing streak: When easing back into the markets following a sizable loss or a few consecutive losing trades, a smaller position size can help calm your emotions as you aim to restore order and rebuild lost or shaken confidence.
When trading a low-probability reversal set-up: Although part of a balanced, long-term trading approach, trend reversal set-ups represent high-risk, low- probability trading opportunities that are sometimes difficult to execute. For ultra-conservative traders, though, it would be possible to decrease the initial position size by one half, and then add to it later on pullbacks in the event that the reversal is confirmed and a new trend begins.
In the name of risk and money management and to remain disciplined in your trading approach, do not risk more than 2% of your account value on any given trade. While it may be tempting to trade larger size, say, when a set-up is especially clear and well defined on the chart, or if you’re in the midst of a recent winning streak, or even if you just “Have a good feeling” about a particular trade, the reward is simply not worth the risk.
Particularly when trading a modest account for the long term, no single win is worth risking an oversized loss to attain. Instead, remain committed to trading small and consistently so as to absorb only small losses your wins can more than account for. Be highly disciplined and conservative with regard to position size for your best chance to grow and sustain your trading account for the long term.
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