Size Does Matter
By Michael
I hate to say it, but regardless of what you’ve all heard:
Size Matters
Well, in trading anyway!
I’m sure you’re all aware of the “L” word. It puts a fearsome spin on the markets that are commonly traded in contract form (i.e. forex, futures & options). The word that casts the long shadow, my friends, is LEVERAGE - and coupled with the size of your trading position, it can mean healthy gains or a quick and painful trading demise.
Position sizing is important - especially for small money-managers and independent traders because not being able to properly size your trades is an accident waiting to happen. Being able to leverage is an important privilege that is afforded to us by the forex market but like all privileges, it is abused. I love looking at the ads in the internet for forex asking if you like the idea of turning $5,000 into $25,000. Sure, it sounds great but knowing what I know about trading (which is not a lot, really), that ad could very well be the same as: “How would you like to turn $25,000 into $5,000. Of course no one wants that to happen but it does for many people who buy into much of the forex hype. The two major sides to leverage is that on the one end, you can make a lot of money if you’re aggressively anted up (trading large), but you can also lose everything in a matter of minutes - sometimes, seconds. What tends to happen to a lot of beginners and some advanced traders is that they get a couple of trades right and then get overconfident, risk everything on what appears to be a benign trade and then blow up as the market coldly proves them wrong.
The thing about forex is; if you’re right, you’re right BUT if you’re wrong - then you’re really, really….and I mean really wrong. The steep learning curve, couple with the privilege of leverage acts as an accelerant to what is usually a mundane market experience for more seasoned forex traders. Many who come into the field sometimes take their retail equity experience with them. Consider this example: Let’s say that you’re trading stock ABC at $40/share with a $2,000 account. With your present capitalization, you can control about 50 shares or so if you decided to go all in. Now with 50 shares, when you lose 100 ticks (the stock goes down to $39), you’ve lost about $60 (counting commissions). However, take that trade and apply it to the EUR/USD pair on a $2,000 account and you max out on one position you think will go your way. If your position is correct; well - sky’s the limit BUT if it’s wrong and the euro takes a knockout blow to the floor, you may very well lose something in the neighborhood of $1,500. Of course, this is a worse-case scenario but you can now see the difference between an equity trade and a forex trade with the ability of standard leverage. The difference is night and day. This of course is not meant to disparage equity trading/traders. After all, there are advantages to the markets NOT being open 24 hours a day if you play certain strategies. What I want to show is that the contractual ability that forex trading gives makes traders here (and in the futures and options markets) naturally more sensitive to each and every tick of their trade. Sheepishly switching time frames to “avoid” owning up to a loss is the ultimate recipe for disaster.
So, the end question is; “How does one size their positions effectively, whereby being able to take advantage of the market without the market overwhelming our trading capital base?” Well, I’m not in the position to give an end-all be all answer but I can give suggestions. One way, is to size your positions according to the amount of equity that you have. For example, you have $1,000 to trade. Well, where very inexperienced traders would assume that this is enough to go big size with (a very wrong assumption, but that’s just me), you’d have to think realistically as to how many bad trades you can weather if you decide on trading anywhere from 10K lots up to 100K lots. You also have to remember that as you get bigger, your pip allowance until you get margin-called gets smaller. Another way to determine your trading position size is to see how much downside risk you’re going to incur. Many traders I know cut their positions by as much as ¾ of their normal load if the trade’s risk exceeds 50 ticks. This is not common at all - but you have to find all this stuff out for yourself and see what you’re comfortable with. The beauty of this latter method is; if you lose, you lose small, but if you win - not only do you win, but if you feel that the market is on your side, you can add to your position en route to a big payday.
So there you have it, a quick drive-by presentation as to the importance of position sizing. Remember that the standard leverage given to us by the forex market is a privilege that must never be underestimated; it can be harnessed to produce returns rivaling those of smaller hedge funds or - if misused - can be like collecting crocodile eggs - with the mother crocodile walking right up behind you. But with proper position sizing - you’ll be able to put yourself in a position where you can enjoy the fruits of good trading and withstand the inevitable losing streaks. All this, while gradually increasing the equity of your account for the long term. And when you’re positioning yourself for worst-case survival as well as gains, your trading success is that much more certain.
Happy Profits!
Posted in Categories: Contributor, Forex, Psychology.
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