*Learn how to calculate your exposure and size positions correctly!*
Happy Friday Everyone. I have written this blog post with the intention of showing new and less experienced traders how to calculate their risk for trade positions and use this to size positions correctly to stay within your risk profile. This is a very simple task but one that a lot of new traders tend to ignore and ultimately end up risking too little or too much which can negatively effect their performance.
Let’s briefly discuss long term performance and the key factors that influence it. Essentially, long term trading performance is made up of 2 KPI’s (Key Performance Indicators) – Win Rate % and Reward:Risk (R:R) ratio. They are pretty self explanatory but the total amount of profit made from your winning trades minus the total amount of loss made from your losing trades equals your final “net” profit (or loss).
There are 2 ways to improve performance… win more trades or increase your average R:R ratio. If you can improve both then that’s even better. Improving your win rate % is down to the quality of your analysis and your ability confined and enter high probability positions. Improving your R:R ratio is even more simple… keep your losses small and your wins big. Let your winning trades run and cut your losers quickly.
Below is a chart that shows what the power of a good Reward:Risk can do to your overall profitably in the long term. You don’t need to win every trade if you manage your risk correctly and capitalise on the winners.
If you look at the data shown above, you can see that if you manage to average a Reward:Risk ratio of 3:1 on your trades you only need to win 1 in 4 of your trades to not lose capital. If more than 25% of your trades are winners then they are contributing to your long term profitability and growth of capital on your account.
As you probably know, the Reward:Risk ratio of a trade is made up of 2 components – your total reward taken on the trade and your total risk. You will quite often see the reward variable increase & decrease as trades go on because you can hold trades for longer and increase the reward but the risk variable is set in stone and you should know your intended risk (or exposure) of your trades before you enter the position.
Now let’s look at how I calculate risk for an initial position aswell as the continual management of exposure as the trade runs. These are the 4 simple steps to calculating the required risk for a trade entry.
- Use Technical Analysis to find your stop loss placement
- Measure the number of pips from entry price to stop loss
- Decide your risk value for the position as a % of account capital (I will use 1% for this example)
- Use the MyFxbook position size calculator to work out the exact number of contracts you need to purchase for your required risk (link below)
The position size calculator on MyFxbook is a huge time saver and it means you don’t have to manually calculate your required contract size for your risk. For the purposes of this blog post I will explain how the calculation works anyway.
EURUSD FX Currency Pair
- Entry Price 1.12
- Stop Loss 1.117 (30 pips)
- Account Balance £100,000
- Required Position Risk 1% or £1000
Firstly you need to divide the risk value by the number of pips for the stop loss to get the pip value. So £1000 / 30pips = £33.33 per pip
You then need to check your trading account and confirm if you are trading standard lot sizes or not. If you are trading standard lot sizes then 1 lot = 100,000 contracts of EURUSD which means you would purchase $112,000 worth of EURUSD contracts at the current market price.
If the USD is the second currency in the pair (EUR/USD) then the pip value is fixed at $10 per pip for 1 standard lot traded.
To calculate this as a GBP value to calculate your required number of lots for your desired risk then you simple divide the $10 pip value by the current GBPUSD exchange rate. Let’s assume this is 1.30 for this example and then the pip value is £7.70 per pip.
As we calculated earlier, you can have up to £33.33 per pip at risk to keep within the desired risk of 1% of account balance per position. If 1 standard lot is £7.70 then simply divide £7.70 in to £33.33 to get the multiplication factor of 4.32 and multiply that by 100,000 to calculate how many contracts you need to purchase. Which is 432,000 EURUSD contracts.
As you can see in the picture above, the position size calculator works all of this out for you in seconds. Although the GBPUSD ask price is different (1.287 not 1.30 as I used) the results are pretty much the same with the difference caused by the conversion from USD to GBP.
Managing risk on open positions:
So you have entered your initial position on a trade and it is now going your way, great! Now you need to manage your exposure as the trade continues in order to avoid taking unnecessary losses.
I would advise practicing with the breakeven method because it can also cause you to miss out on greater returns on capital if you go too aggressive and remove exposure too early.
Another key part to continually managing your risk is to stay on top of position sizing when you scale in to trades. If you are entering a longer term swing trade position then you are most likely going to capitalise on any intraday pullbacks and buy the lows/sell the highs on the lower timeframes to further increase your returns from the overall market swings. This is perfectly fine and I am also a massive advocate for doing this and capitalising on the natural swings of the markets as much as possible but you need to remember to manage your total exposure and not just each position.
Firstly, I will only enter a 2nd position on a financial instrument once my original position is in profit and exposure is net zero. This can be done by using the breakeven method explained above. I can then focus on the scale in position and follow the exact same steps for calculating the correct position size as I did for the original entry. I will look for where my stop loss needs to go, calculate the desired pip value and then use the MyFXbook position size calculator to tell me how may contracts I need to purchase (or sell if shorting). You can repeat this for every scale in opportunity and extra position that you add.
I don’t add to losing positions because that is guaranteed to increase total exposure and you will be immediately operating outside of your desired risk levels. By only scaling in to trades once the previous positions are in profit and free of any risk you can exponentially increase your returns made on the market swing whilst maintaining your original level of risk. Perfect!
So there we have it, this is my simple process for how I manage risk on new trades and also existing trades that I am managing. I highly recommend you take note of the link to the MyFXbook position size calculator but I have put the link on the Helpful Trading Tools page of my blog.
Remember to like and follow this blog post to stay up to date with all the latest posts and updates 🙂 Have a good weekend everyone!
DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.