UNIT C| System Modeling

3.The Position Size

Risk management occurs when, before you enter the market, you ask yourself: How many lots am I going to buy or sell? This is a question that every trader has to answer ultimately, whether they do it consciously or not. The following sections will enable you to apply a precise formula and answer that question consciously instead of just pulling something out of your hat. Position size is a decision that everybody makes so you'd better do it consciously and follow a plan.

In Ralph Vince's experiments (see the previous section), the forty participants had a constant Win Rate of 60% and a constant Payoff ratio of 2:1. From there on, they had to find a risk management strategy. Good money managers realize there is not much they can do about luck and Payoff and that success in speculative trading often hinges upon the size of each position. This means setting a maximum loss scenario and being disciplined enough to stick to it.

Too many traders invest inconsistent amounts in each trade whereas they have only to follow a few rules. Being inconsistent or oversizing a single trade will lead to Drawdowns in your account that could wipe you out. Knowing how much you have at risk in a single trade compared to your total capital will help your trading to become much more stable.

How To Calculate The Position Size?

Using the distance between your entry point and your stop loss is the most effective way to determine the maximum risk amount. Traders can tailor their positions to stay consistent with their maximum tolerable losses, for example by reducing the position size if the stop is further out.

To size a position, you need to know:

• How much money you have to trade
• What percentage of your money you are willing to risk
• What is the distance between the entry price and the stop loss for every trade
• What is the pip value per standard lot of the currency pair traded

Imagine that you have an account with 10,000 US Dollar and you are ready to lose 2% in a bad trade. You are considering a position on the USD/JPY and the stop loss for that trade is set at a distance of 50 pips. The current pip value per standard lot is, let's say, 9,85 US Dollars. You are now ready to calculate your position's size by using the formula:

Position size = ((account value x risk per trade) / pips risked)/ pip value per standard lot

 

((10,000 US Dollars X 2%) / 50) / 9.85 = (200 USD / 50 pips) / 9,85 =
4 USD / 9,85 USD = 0.40 standard lots (4 mini lots or 40.000 currency units)

 

In case you are going to open several positions, the same equation would be used to limit the overall risk in all the open positions. The only difference is that a maximum number of open positions has to be set beforehand and a partial risk attributed to each one of the positions.
For example, take the same 10,000 US Dollar account and limit the overall risk to lose at 6%. Now attribute to each trade a certain amount of risk until you sum 6% - from there one, no new positions can be opened.

One of the characteristics of risking a fixed percentage is that it forces the trader to think in terms of percentages and not pips. By risking always the same percentage you can make a profit even when the total net pip amount is negative. The following table shows an example:

Risk Measures Based On Equity

The position size calculation outlined in the previous section refers to the total  capital in our trading account, in terms of account balance. The money management techniques we are going to see can greatly improve assuming that there are other ways to evaluate our total capital.

Instead of deciding how much margin to risk based on the account balance, you can use the equity. Equity should be understood as how much money you really have at any point and time.

There is a common confusion as to what is the account equity and what is the account balance. In trading there is amisconception that the more money you have the easier it is to make money. But in reality, the size of a trader’s account has absolutely, positively nothing to do with the amount of return that trader can get.If you have a 1,000 or a 100,000 US Dollar account and use 40% of the margin on the trades, you are taking on the same amount of risk- in terms of % (not in absolute terms)!

Let's differentiate things by deploying three basic models where equity can be used to calculate the position size:

Core Equity Model - Free Margin

It's important to understand what's meant by core equity since your money management may depend on this equity. The core equity is the margin available to trade.

Core Equity = Account Balance - Amount used in Open Positions

For example, suppose you are not leveraged, you have a balance of 10,000 US Dollar and you enter a trade with one mini lot (1,000 US Dollars), then your core equity or free margin is 9,000 US Dollars. If you enter another 1,000 US Dollar trade, your core equity will be 8,000.

It is the simplest model of all, as it only takes into account the amount required to open a position. Our core equity capital is equal to the initial core equity minus the amounts for each of the positions regardless of how they develop.

As your core equity rises or falls you can adjust the dollar amount of your risk.  Following the above example, if you wish to add a second open position, your core equity would fall to 8,000 and you should limit your risk to 800, should the limit be of 10% of the available margin.

By the same token you can also raise your risk level as your core equity rises. If you have been trading successfully and made a 5,000 US Dollar in profits, your core equity is now of 15,000 US Dollar. You would relate your risk to the new adjusted core equity per transaction. At some point, it means also you could risk more from the profit than from the original starting balance. Some traders may even increase the risk in the realized profits for greater profit potential. We shall see this technique further in this chapter.

Total Equity Model

According to this model our level of equity is determined by the total amount available in the account balance plus the value of all open positions, whether these are positive or negative. This means that if you have open positions in positive, the new position's risk will be calculated in relation to the balance plus the unrealized profits (or losses, in case the positions would be in a loss).

Total Equity = Account Balance +/- Value of Open Positions

 

Reduced Total Equity Model

This model is a combination of the previous two and is a bit more complex. The calculation of equity is the result of the capital used in open positions subtracted from the starting balance (same as in the Core Equity Model), but any benefit resulted from a protecting stop loss (reducing a potential loss or guaranteeing a profit) should be also accounted.

Reduced Total Equity = Core Equity +/-  Protected Profits

 

As explained before, we use the stop loss to calculate maximum risk in the Forex market because a Forex position is a margin position. As a trader you have the obligation to make good on losses, but there isn't a physical delivery of the transacted currency because you are not actually taking possession of 10,000 US Dollars when you trade a mini lot, for instance. What you really own is your obligation, and therefore your position sizing should be based on this rather than the entire notional value (the leveraged position size).
This means also that the risk of ruin becomes huge when you over leverage. Over leveraging is for example if you try to maximize the position sizes based on minimum margin requirements.

 

This is the formula for calculating a position's size taking equity into account (by equity we understand the three mentioned equity evaluations):

Position Size = (Equity x Risked Equity per Trade) / Pips Risked

Core Equity Usage

Since the idea of risk management and not over leveraging accounts remains a lingering issue for many aspiring traders, we are going to run some numbers and use an exercise to calculate the free margin accordingly to the leverage, hoping this will make these concepts a little clearer.

Let's say you have an account balance of 10,000 US Dollar and a maximum allowed 200:1 leverage. At the start, with no open positions, the usable margin is at 100%.

You decide to open a trade using 2% of the available margin. Now, no matter how many pips you think you can pull from a trade, suppose you've decided to use a 2% entry- this is how much margin you're going to use.
And no matter how attractive a trade looks or how promising the Return is, you're going to stay disciplined by only using this set amount of equity.

Here’s how you determine how much a 2% entry is:

• Core Equity (Usable Margin): 5,000 USD
• Used Margin: 2%
• 5,000 X 0,02 = 100 USD

With a 200:1 leverage an entry of 100 US Dollars will net you 2 US Dollars per pip. The reason is that 100 US Dollars leveraged 200 times is 20,000 USD which equals to 2 mini lots, which in turn pays approximate 2 US Dollars per pip.

So after the trade is executed, your account shows:

• Balance: 5,000 USD
• Usable Margin: 4,894 USD (entry size plus the spread of 3 pips at 2 USD per pip = 6 USD)
• Used Margin Percentage: 2.1% (after factoring in the spread)
• Entry Price: 1.3790

Market moves against you by 20 pips and is now at 1.3770. After the market moves against you, notice how the used margin percentage changes:

• Usable Margin: 4,854 USD
• Used Margin Percentage: 3.0% (4,854 - 5,000 = 146 USD → 146 / 4854 = 3.0%)

The exchange rate moves against you another 30 pips and is now at 1.3740. Again, this alters the used margin and therefore free (usable) margin:

• Usable Margin: 4,794 (30 pips of Drawdown at 2 USD per pip = 60 USD →  60 – 4,854 = 4,794 USD)
• Used Margin Percentage: 4.3% (4.794 – 5.000 = 206 → 206 / 4.794 = 4.3%)
• Usable Margin Percentage: 95.7% (100 - 4.3 = 95.7%)

This is basically how you do the math to determine your margin usage, your available margin, and what kind of risk exposure you have in the market. The other critical component is knowing how far the market can move against you before you damage your account.

Continuing with this exercise…

• Usable Margin: 4,794 USD
• Entries: 2
• Price Per Pip: 4 USD (2 entries at 100 USD each, leveraged 200 times = 4 USD per pip)
• Used Margin Percentage: 4.3%
• Usable Margin Percentage: 95.7%

With an usable margin of 4,794 USD and each pip movement accounting 4 USD, the market would need to move 1,198 pips against you before you get a margin call.

4,794 USD / 4 USD per pip = 1,198 pips (4 USD X 1,198 = 4,792 USD)

That means the exchange rate would have to go to 1.2542 before a margin call happens: (1.3740 - 1,198 pips = 1.2542)
As long as you are not over-leveraged, you can withstand the Drawdowns.

Again, as a risk and money manager, it is imperative you know these simple and basic calculations.

In this example you had a 200:1 leverage. Does this mean you can risk more because just because you are leveraged? Absolutely not, it means you can risk less in terms of percentage and get the same reward.

Never let your margin fall below your broker's required threshold. When you have open trades, always monitor what is happening to your margin. Some margin calls occur when your margin falls below 30%, some brokers call at 20%. Find out what are the requirements of your broker.