Position sizing is important to understand in order to prevent over-exposing/over-leveraging your account, position sizing is very important to ensure trading consistency. About 77% of retail traders lose their whole account due to incorrect risk management. This article goes through some basics on how to calculate your risk/exposure on a trade.
What is a “lot” in Forex?
There are three popular types of lots in Forex Trading; standard, mini and micro lot. They represent a certain amount of unit of a base currency you are trading. A standard lot is 100,000 units of a currency, a mini lot is 10,000 units of a base currency, while micro lot is 1,000 units of a base currency.
What is leverage?
Leverage is the use of borrowed funds to increase one’s trading position beyond what would be available from their cash balance alone. Most Forex brokers have a 100:1 leverage for their standard account. Usually to trade a standard lot, you would require \$100,000 of the base currency, however with a 100:1 leverage (100x), you are able to trade \$100,000 of a base currency with just a \$1,000 account. Leverage is a double edge knife, if used correctly could help increase your profits, but also incorrect usage could over expose your account.
What is a pip?
A pip is the unit of measurement of the change in value between two currencies. For most currency quotes, 1 pip is the change in the 4th decimal value (1 pip = 0.0001). There is an exception for Japanese Yen which is the change in the 2nd decimal value (1 pip = 0.01). Understanding what a pip is important since the change in value between currencies is how Forex traders make money.
In this AUD/USD daily chart, the most recent candle stick showed a gain of 31 pip equating to a 0.46% price increase for the Aussie Dollar.
Pip Value
With an understanding of lots, leverage and pips, we can now figure out the value of a pip. Understanding the value of a pip with the currency you are trading is important to help understand the potential upside or risk of a trade, you would like to execute based on the size you are trading.
Pip calculations is based on the pair you are trading and your lot size. Since we are in Australia, pip values will be in AUD.
For pairs that have AUD as the base currency e.g. GBPAUD, EURAUD, the calculation is very simple.
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$$ \frac{\textsl{lot size}}{10000} = \textsl{pip value} $$
So assuming you are trading 1 standard lot which is 100,000 the base currency. The pip value will be 10 AUD.
$$ \frac{100,000}{10,000} = 10 \, AUD $$
For pairs without AUD as the base currency e.g. AUDUSD, EURUSD, USDCAD, the calculation is bit more complicated.
$$ \frac{1}{\textsl{AUD / Base Currency}} \times \frac{\textsl{lot size}}{10000}=\textsl{pip value} $$
The AUD / Base Currency is just finding the exchange rate of AUD against the base currency. For example to find the pip value of trading 1 lot of USDCAD. We will first need to find the exchange rate for AUD and CAD (as of 16 Nov) 1 AUD = 0.9 CAD.
$$ \frac{1}{0.9} \times \frac{100,000}{10,000}=11.11 \, A U D $$
With the calculations we find that each pip for when trading 1 lot of USDCAD is 11.11 AUD.
Risk Management
By understanding the basics above, a risk management plan can be generated. A general rule of thumb for most beginners is risk at most 3% of your account each trade. This ensures that you do not risk too much per trade. Risk is essentially the maximum amount you are willing to lose before you close your position.
For example if you have a \$1000 account, the most you should risk following that rule is \$30. But if you look at the pip value for a standard lot calculated in the previous section, they are all above 10 AUD for each pip. Hence following that rule, you can only risk at most 3 pips per trade. Which is close to impossible, hence you will need to reduce your lot size.
Lets say you decide to reduce your lot size to a mini lot (10,000)
$$ \frac{10,000}{10,000}=1 \, A U D $$
Each pip would be $1 dollar instead which is allows you up to 30 pips of price movement against you.
Trade Example with Risk Management
Assuming I have a \$10,000 account, with the 3% rule, my maximum risk for the trade would be \$300. Through technical analysis, I find a trade opportunity on GBP/USD daily chart.
My short target is at 1.27 at the 0.382 fib retracement and 200 SMA, with a stop lost at 1.29672 a previous lower high. The stop lost is about 69 pips away from current price. Dividing \$300 by 69 we get around 4 AUD per pip. The current exchange rate for 1 AUD is 0.68 USD.
Rearranging this equation
$$ \frac{1}{\textsl{AUD / Base Currency}} \times \frac{\textsl{lot size}}{10000}=\textsl{pip value} $$
$$ \textsl{lot size}=(\textsl{pip value}) \times(\textsl{AUD / Base Currency}) \times 10,000 $$
$$ \textsl{lot size}=(4) \times(0.68) \times 10,000 $$
$$ \textsl{lot size}=27,200 $$
27,200 has an estimated equivalent size of 0.27 lots. Hence we have determined that the maximum lot size I should do is 0.27 lots.