Sensible position sizes

On another thread (on the Rate My Broker forum) Dale Paterson included this comment in one of his posts:

I have to disagree with my good friend from Johannesburg.

[B]I think the 2% risk rule is appropriate for very small accounts, just as it is for larger accounts. [/B]

Basically, the 2% risk rule says: on each trade, determine your risk exposure in pips, and set your position size such that the dollar-value of your exposure is not more than 2% of your account balance. If you just love to do math all day, then you can run these calculations prior to each trade you enter. But, there’s a much easier way.

[B]The Lazy Man’s Way to Determine Position Size[/B]

  1. Determine your maximum stop-loss setting. In my case, that number is 50 pips. The way I trade, a 50-pip stop-loss (or less) is totally sufficient, and I’m just not comfortable setting a stop-loss further away than that.

  2. Calculate the maximum leverage you can use, such that a maximum loss in pips will produce a 2% loss in your account.

  3. [B]Use that same leverage on every trade[/B], whether you are using your maximum stop-loss, or not.

In my case, my personal maximum 50-pip stop-loss corresponds to 4:1 leverage. And this is the leverage I use on every trade.

Let’s check the numbers, to prove that 4:1 leverage and a 50-pip stop-loss will limit risk to 2% of account balance, regardless of what the account balance is.

Example 1. You have a $500 account. 4:1 leverage means each trade is 2,000 units of currency, which equals 2 micro-lots. This is your maximum position size on every trade. If you are stopped out, your loss will be 50 pips, which equals $5 per micro-lot, or $10 for your 2-micro-lot position. $10 is 2% of your $500 account balance.

Example 2. $1,000 account. 4:1 leverage. 4,000 units of currency = 4 micro-lots.
Stop-loss: 50 pips = $5 per micro-lot = $20 total loss = 2% of account balance.

Example 3. $3,500 account. 4:1 leverage. 14,000 units of currency = 14 micro-lots.
Stop-loss: 50 pips = $5 per micro-lot = $70 total loss = 2% of account balance.

Example 4. $20,000 account. 4:1 leverage. 80,000 units of currency = 8 mini-lots.
Stop-loss: 50 pips = $50 per mini-lot = $400 total loss = 2% of account balance.

Example 5. $100,000 account. 4:1 leverage. 400,000 units of currency = 4 standard lots.
Stop-loss: 50 pips = $500 per standard lot = $2,000 total loss = 2% of account balance.

If you’re not comfortable with a 50-pip maximum stop-loss, and prefer some other limit to your exposure, then calculate the leverage which corresponds to the stop-loss you’re comfortable with. Similarly, if you’re not comfortable with a 2% risk to your account balance on each trade, then calculate the leverage which corresponds to your risk tolerance.

Once you have set a limit on your risk per trade, you can use the same leverage limit on every trade, without a lot of number-crunching. If your broker defines position size in term of lots (nano-, micro-, mini- or standard), then as your account balance takes on various values, you will have to round down to a whole number of lots, when you are establishing position size. But, you can do this in your head.

Most new traders, with tiny accounts and dreams of big profits, grossly over-leverage their accounts, risking far more than 2% of their account balance on each trade. This is a formula for disaster.

2% is a prudent MAXIMUM risk figure, in my opinion. For some traders, less is even better.

ONE ‘t’ Clint!!! It’s ‘Paterson’ with ONE ‘t’!!! LOL!!! (I think you’re the first person to ever quote my surname in a post)!!! LOL!!!

First of all: as usual a fantastic post of yours above!!! You sure do go out of your way for everyone here that’s for sure. Thank you from me anyway.

Your information is 100% ‘spot on’!!!

I guess I should qualify my post (instead of scaring everyone off) by saying this:

Much of ‘the way I think’ is based on futures trading.

Here’s an example from TODAY Larry (see my post entitled ‘Aged Trading Examples’ in ‘The Melting Pot’ forum if you’ve not seen it already):

On the Dow (daily):

My trading system generated a signal to go long the Dow at 10 290. The initial stop for this trade would currently be at 9 561. That’s a potential loss of $729 per contract (at $1 per point movement). In order to take this trade: one would require a capital balance of $36 450 (2% risk). OK: if you move to a lower timeframe then your 2% risk amount, and therefore your capital requirement, becomes less but, of course, you then increase the risk of false signals and whipsaws.

I guess what I’m trying to say is that your capital requirement depends on many factors including (but probably not limited to) the leverage, the broker, the timeframe being traded, the instrument being traded, and the trading system or methdology being traded.

Moving on to forex pairs (if I MUST):

EUR/USD daily chart. I currently have a signal to go long EUR/USD at 1.3033. If that order were to be executed: the stop loss would be 1.2517. That’s a potential loss of 516 pips (this pair today is actually a precise example of why I was saying what I was saying in the other thread). Let’s assume that the trader was trading micro lots (the minimum size lot that Delta offers of 1 000 units i.e. remember that the other thread was for a broker recommendation). The trader would be getting $0.10 per pip movement. Multiplied out: the traders risk in this case would be $51.60 therefore requiring capital of $2 580 to take this trade (2% risk).

Again: if you shorten the timeframe the same applies as noted above.

Do you see where I’m (was) coming from???

Using the EUR/USD example above: to take that same trade but trading ‘nano’ lots at another broker (IBFX for example) then the trader would only require capital of $258.

Make sense???

Regards,

Dale.

I’ve corected my speling eror. Sory about that.

Ah, position trading, with huge stop-losses. That is a different breed of cat, altogether, isn’t it? The same math applies, of course. But the idea of “leverage” gets turned on its head, when the allowable loss is so big.

In all cases, the 2% risk rule requires a trader to have an account balance which is 50 times the dollar-value of his largest stop-loss. In the case of your EUR/USD trade, our intrepid trader must have an account balance which is 25,800 times the dollar-value of 1 pip.

Your math is absolutely correct. In order to take a 516-pip loss, and endure only a 2% loss of capital, our trader would have to have an account balance of:

$258 if trading 1 nano-lot (with 1¢ pips),

$2,580 if trading 1 micro-lot (with 10¢ pips),

$25,800 if trading 1 mini-lot (with $1 pips), and

$258,000 if trading 1 standard lot (with $10 pips).

In each of those 4 cases, the concept of leverage is meaningless. No leverage is possible. In fact, the trader can’t even use 1:1 leverage. In order to adhere to the 2% risk rule, the trader must use “reverse leverage” of 0.38:1. That is, his position size can be no larger than 38¢ for each $1 in his account!

There are several reasons why I have no stomach for position trading — and that’s one of them.

Hello again,

Nice post (again)!!! Thank you.

This I like:

There are several reasons why I have no stomach for position trading — and that’s one of them.

I don’t have the stomach for it either but it’s the only way I know. Put another way: it’s the only methdology that’s worked for me CONSISTENTLY and it’s taken a long time and HUGE losses for me to conclude this.

LOL!!!

By the way: I hope that you DO KNOW that I was only ‘messing with you’ (about you spelling my surname incorrectly)??? LOL!!!

Thanks again for all your excellent posts Clint. You provide a wonderful ‘service’ here.

Regards,

Dale.

I knew that.

Have a great weekend, Dale.