An effective money management strategy involves what is known as “position sizing,” which as the name implies consists of determining what size position you are going to take on a particular trade.

Position sizing can be performed in a number of ways form the simple to the complex. The best rule of thumb in making a choice between them is to choose the one that works best with your system. As we have learned in the previous sections, what we want in a good position sizing technique is to be able to easily handle the losing trades so that we can continue to trade the winning trades and have a profitable system.

Let us have a look at three position sizing models:

  1. Fixed Lot Size
  2. Equity Percent
  3. Advanced Equity Percent With Stop Loss (Fixed Fractional)

 

1) Fixed Lot Size

Excellent for newbies, fixed position sizing means that the trader will trade with the same position size, preferably a small one. He may change the lot size at different intervals as the account increases or decreases.

What size position is preferred for the account size?

It all depends on the account size, of course, but the rule of thumb is to keep your trade size as small as possible, preferably at 2:1 leverage or less:

Example #1: $5000 Mini Account
At 2:1 leverage per trade, start with 1 mini lot
(reason: 1 mini lot is 10000 units, and thus 2 times greater than account size)

Example #2: $500 Micro Account
At 2:1 leverage per trade, start with 1 micro lot
(reason: 1 micro lot is 1000 units, and thus 2 times greater than account size)

Benefits Drawbacks
  • Excellent for newbie documentation and education because of its consistent lot size.
  • It can grow profits arithmetically by a constant amount over a given time period. Some traders or systems may perform poorly if the account is allowed to grow exponentially. Others prefer to trade with a large account and withdraw profits regularly.
  • Limitation to a static pip value may be too simple a position sizing technique for seasoned traders / systems wanting a bit more sophistication and instead may benefit from other position sizing approaches discussed below.
  • It does not provide an ability to maintain a constant leverage as account balance shrinks and rises, leading to slow growth and large draw downs.
  • Very inefficient method of growing account: a fixed lot size of 1 micro lot for a $500 account can slowly double it about 5000 pips, but to make it double again after that, you would need 10000 pips.

 

2) Equity Percent

This method has you determine the size of your position based on percentage changes in equity. You specify the percentage of equity that each position should take. The method can allow for geometric growth of equity because the size of the position grows in relation to the equity growth of the account. Though you can trade more aggressively with an increase in % of equity, you should always remember that the larger the percentage, the more potential profit as well as potential risk.

What percent of equity should one trade with?

It is usually safer to trade with a smaller percentage of equity, such as 1% or 2%. I prefer to trade with 2% of Equity, which equates to using 2:1 leverage per trade, because it allows me to stay in the game longer. However, if I am trading more than 1 system in the same account, I will trade with 1% of equity, which equates to using 1:1 leverage per trade (no leverage).

The Equity(%) formula is:

Number of Units = Equity * Risk(%) / Contract Size *  Leverage

Here is a $7,000 account wanting to trade with 2% Risk:

Equity: $7,000
Risk%: 2%
Contract Size = 100,000
Leverage = 100

Lots = Equity * Risk(%) / Contract Size *  Leverage
Lots = (7,000 * 0.02) / 100,000 * 100 = 0.14 lots

Note: For FX pairs, contract size is always going to be 100,000. Leverage will change between brokers, but it is a good idea to keep it at 100, even if the broker grants you 400:1 leverage. Equity is self-evident. Thus Risk% as the only real adjustable variable.

Here is a simple formula coded up in MQ4:

extern double Risk = 2.0;

//Custom Function, Lots()
double Lots()
{
double vLots = NormalizeDouble(AccountEquity() * (Risk/100) / 10000 *100, LotDigits);

return(vLots);
}

 

Benefits Drawbacks
  • Profit compounding or geometric growth of equity. When used with a conservative Risk%, it can rapidly increase the lot sizes based on the equity growth and risk%.
  • Preservation from Loss. Size of the trade stays proportional to the equity, so as account losses, the lot size gets smaller and smaller, preserving account from rapid ruin. Decreasing the size of the trades during a losing streak minimizes the damage to the trader’s equity.
  • If you have a small account balance you are forced to work with a lot size which doesn’t help in fine sizing the positions. Smaller account sizes it will take a long time for this money management to actually kick in.
  • If a large loss exceeds a certain amount and the risked percentage is now less than the smaller lot size, the trader is forced to break the risk rules just to trade the minimum allowed lot size.
  • The reduction of the relative position size after every loss makes it more difficult to recover from a severe Drawdown.
  • Once the account reaches a higher size, the growth of the position size accelerates to a degree which is unrealistic and highly risky, unless Risk% is reduced.
  • There is a tendency with newbie traders to start out with a more aggressive Risk%, such as 10% Risk. This can be fatal. Using greater than 2% Risk can allow you to profit more on the good trades, but when you have a run of back luck, the losses can dramatically pile up.
  • Does not take into account trade risk, so if the stop loss is too large the %Risk that is applied to it can be a large blow to the account.

 

3) Advanced Equity Percent With Stop Loss (Fixed Fractional)

The idea behind fixed fractional position sizing is that the number of units you trade with is based on your pre-determined percentage risk per trade and your stop loss distance. The risk is the same percentage of account equity on each trade and is related to your changing equity and stop loss size.

How does one calculate the % risk per trade and the stop loss amount in order to derive the lot size?

Let us break it down in three steps:

  1. Calculate your % loss comfort level per trade. You need to be comfortable losing on any one trade because you can lose on many of them. Generally, you should anticipate losing on 10 consecutive losing trades and try not to exceed a 25% draw down, which means that you should consider risking only 2% on each in order to survive a 10 trade losing streak.
  2. Determine your stop loss level. Generally will have optimized and back tested your system to determine the appropriate stop level. You should never place your stop too close to your entry in order to trade higher lot size.
  3. Determine your lot size based on % risk and stop loss level. You need to determine the number of mini or micro lots to trade that will give you the % risk you want with the stop distance you have decided is most logical to your system. For instance, since one micro lot is $1 per pip, and you have a pre-defined risk of 2% of a $10,000 account ($200), and your stop loss distance 50 pips, you will trade 4 mini lots ($4 per pip x 50 pip stop loss = $200 risked.

Furthermore, you should be following two rules:

  1. Rule #1: You should never adjust your stop loss to meet your desired position size; instead you always adjust your position size to meet your pre-defined risk and logical stop placement.
  2. Rule #2: You you will be trading the same risk on every trade, though the lot size may vary depending on the stop loss size. If you have a wider stop you don’t risk more money on it and if you have a narrow stop you don’t risk less. Instead, you are adjusting your position to meet your pre-determined risk amount, not risking more or less.

The fixed fractional formula is:

Lots = Equity * Risk% / (Stop Loss in Pips * Pip Value) / 100

Let us use the above equation to solve this $5000 mini account scenario:

Equity: $5,000
Risk Percent: 2%
Stop Loss: 50 pips
Pip Value: 10

Lots = Equity * Risk% / (Stop Loss in Pips * Pip Value) / 100
Lots = 5000 * 0.02 / 50 *10 / 100 = 0.20

Let us use the above equation to solve this $300 account with 30 pip stop loss:

Equity: $300
Risk Percent: 2%
Stop Loss: 30 pips
Pip Value: 10

Lots = Equity * Risk% / (Stop Loss in Pips * Pip Value) / 100
Lots = 300 * 0.02 / 30 *10 / 100 = 0.02

Here is a simple formula coded up in MQ4:

extern double Risk = 2.0;
extern double StopLoss = 30;

//Custom Function, Lots()
double Lots()
{
double vLots = NormalizeDouble(AccountEquity() * (Risk/100) / StopLoss * 10 / 100, LotDigits);

return(vLots);
}

 

Benefits Drawbacks
  • Fixed risk position sizing is one of the only position sizing methods that directly incorporates trade risk. It is simple but very effective. When the account equity increases due to accumulated profits the position size increases proportionally. The reverse happens when the account equity decreases and everything is dynamic.
  • Profit compounding or geometric growth of equity. When used with a conservative Risk%, it can rapidly increase the lot sizes based on the equity growth and risk%.
  • Preservation from Loss. Size of the trade stays proportional to the equity, so as account losses, the lot size gets smaller and smaller, preserving account from rapid ruin. Decreasing the size of the trades during a losing streak minimizes the damage to the trader’s equity.
  • If you have a small account balance you are forced to work with a lot size which doesn’t help in fine sizing the positions. Smaller account sizes it will take a long time for this money management to actually kick in.
  • If a large loss exceeds a certain amount and the risked percentage is now less than the smaller lot size, the trader is forced to break the risk rules just to trade the minimum allowed lot size.
  • The reduction of the relative position size after every loss makes it more difficult to recover from a severe Drawdown.
  • Once the account reaches a higher size, the growth of the position size accelerates to a degree which is unrealistic and highly risky, unless Risk% is reduced.
  • There is a tendency with newbie traders to start out with a more aggressive Risk%, such as 10% Risk. This can be fatal. Using greater than 2% Risk can allow you to profit more on the good trades, but when you have a run of back luck, the losses can dramatically pile up.
  • This method cannot apply to trading strategies with varying or unknown in advance exit price levels. If your trading system varies the exit based on the trailing stops or indicator conditions, for instance, then you would be better off using the models above.

 

Tools to Calculate Fixed Fractional Position Size

Online Fixed Fractional Calculators:
A good calculator to help you determine your position sizing relative to your ideal percentage risk per trade can be found here: http://www.earnforex.com/position-size-calculator

MT4 Indicators:

Indicator Descriptor
PositionSize.mq4 Set the % risk level desired, and just drag indicator to your chart to print out on screen appropriate lot sizes for different stop amounts.

 

 

Conclusion

What technique to use? Choose the technique that maximizes your chances of survival and success. First you have to survive, and that means you have to control risk.

Second, you need to figure out your position size.

If you are using a good trend following system which nevertheless produces large Drawdowns from time to time, your first objective should be survival and so you should choose the best technique to achieve that.

If, however, you have a highly reliable system which doesn’t produce either big Drawdowns or big profits, you should concentrate on maximizing those small profits. Remember that the wrong money management applied to your system could actually hurt the end result.

Just as there are no “Holy Grail” trading systems, there is no “one-size-fits-all” money management approach. Each trading system requires a certain money management technique and each technique may be valid for one trader and be useless for another. In addition, the trader’s ability to test and implement that money management strategy has to be considered. The key when choosing a money management model is often self-understanding.

Sizing and managing market positions is often seen like a burdensome, unpleasant activity. And unfortunately, most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss.

Many times traditional advice such as making sure your profit is more than your loss per absolute trade does not have much substantial value in the real trading world compared to the great potential of a sound money management technique.

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Effective Position Sizing Models

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