For many new forex traders, the promise of quick riches is hard to resist. That’s the main reason that every day, many people from all walks of life will begin trading the forex market. While some elements of this “keep your eyes on the prize” mentality is necessary for traders in the difficult times in any given trading day you really should focus on other things first.
When contemplating any established trade, a trader must understand that no matter how perfect the setup, it is possible that something goes wrong and the trade can be a loser. That’s fine – it happens to everyone. Inherent in the foreign exchange market is a degree of randomness. That does not mean that the market is completely random – it is not – but it is so complex that a degree of randomness must exist. It is simply not possible to have all the information that all market participants are reacting to, or to predict how any of them will react to this information. Moreover, this randomness is necessary for the proper functioning of financial markets: If everyone knew the market direction, then there would be no market – a market depends on there always be a buyer and a seller. Chance can not be eliminated but can be controlled.
So back to our setup is not perfect: How could this have happened? Well, as luck would have, as part of their internal accounting quarterly, a multinational corporation at random just happened to be buying the currency you sold, bringing its value – that is, moving the price against position, and trigger your stop-loss. If they were smart and managed this randomness, or risk a logical manner, which can take loss in stride and live to trade another day. This is only part of what each trader may have to spend the afternoon in any proposed dog day.
So how do handle this “risk”? There are volumes of books on the subject, and there are many different methods to achieve this, but in reality what we’re talking about is “how much are you willing to lose on this trade if it goes against you?” The answer must come from money management rules, which is a topic a bit different (we will discuss in a future article). Suffice it to say that most traders live by the rule that no more than 1-2% of your account must be compromised in any one position. What we are dealing with here then is how to ensure that only x% risk of your own? What many believe novice traders is that you must use an x% of their margin on each trade, but that is extremely dangerous and does not conform to proper risk management. The reason is simple: this calculation does not even take into account the configuration of their trade. If you are placing a long-term trading with pip stop loss of 1,000, which could well be facing a margin call long before the price reaches your stop loss level. On the other hand, if you’re putting an intraday trade a 15 pip profit taking, then your gain will be negligible. There must be a way to take into account the exact configuration of commerce and choose your position size accordingly. The business facility must determine the size of the position, not vice versa! This is one of the most critical aspects of the forex retail traders and many simply do not understand (or care). Let us illustrate this with an example:
Say you have a mini account with $ 10,000 MT4 broker that allows you to trade 0.01 lots (minimum volume will be 0.01 x 10,000 = 100 units). Your margin requirement is 1% (which is like saying your maximum leverage is 100:1). Now they say that the current price of EUR / USD is 1.2600 and is a nice layout, you want to go long at 1.2500, as is strong support and analysis says there is a strong likelihood of an upward movement from there should be as low as 1.2500. Their analysis also indicates that if prices fall below 1.2050, the trend is not in your favor and you should exit the trade with a stop loss order. Strong resistance is at 1.3500 and all signs point to reach that level of prices in the coming weeks, so consider this your output target to set your take profit at that level. You will place your order buy limit at 1.2500, but before doing so, it is necessary to calculate the optimal position size. How much you want to buy 1.2500
The wrong way:
Then, remember someone somewhere saying that the use of 1% of your usable margin is the same as running the risk of 1%. You do a quick calculation and see that its position should be a mini lot, or 10,000 units of EUR / USD. Happy with yourself, enter your buy limit order at 1.2500 with a stop loss at 1.2000 (just below your threshold of 1.2050, so that their trade has some extra breathing space).
Unfortunately for you, there is a dramatic increase in the interest of investors demand to hold Spanish bonds, which is an unexpected blow to the euro. Their level of support does not hold. EUR / USD falls below the level of stop loss and just lose their trade. No big deal, you’re risking only 1% of your account. EUR / USD pip value in a trade unit is $ 10 000 1 and lost 500 pips, which means they lost $ 500 and the balance is $ 9,500. But wait, $ 500 is not 1% of your account. It is 5%! The definition of “amount of risk” is the maximum you can lose if the trade goes against you … So if you ran the risk of only 1% of your account, how is it that has lost 5%? There is obviously something very wrong in their calculations. Are not you glad that demo trading? Otherwise it would have been an expensive lesson.
The correct way:
Now you understand that the “amount of risk” is not the same as “used margin”. In fact, they are two very different things. The amount of risk is the amount you can lose if the price reaches your stop loss order. Luckily for you, it’s easy to calculate. Here’s how:
Where:
X is the size of the position (in base currency units), and the value we are trying to figure
R is the% of the account you want to risk
B is the account balance
T is the indicator of long / short: -1 if the short position, if a long position
P 1 is the entry price
P 2 is the “stop loss” (output) prices
Just replace the values and get:
And we get a value:
X = 2,000 units
Yes, the size of the ideal position for the desired configuration would be 2,000 units of EUR / USD. We can do a quick check, because we know that all currency pairs with the U.S. dollar as currency pip have constant values of $ 1 per 10,000 units. Therefore a position of 2,000 units with a value of $ 0.20 nugget. Multiply this by 500 pips and we have a “quantity of risk” worth $ 100, which is 1% of our bill of $ 10,000, so everything comes out. Note that the above formula works for all USD / XYZ and XYZ couple of dollars, but does not work for crosses (ABC / XYZ), since the values of nugget crosses USD depends on the underlying pair of XYZ.
You can also use a variant of the above formula to calculate the “reward” or the amount you can win if trade skillet over how they had expected:
(NOTE: P1 and P2 positions are reversed compared to the risk formula)
Where:
W is a triumph, or amount of “reward” and the amount we are trying to calculate
X is the position size was calculated
T is the indicator of long / short: -1 if the short position, if a long position
P 1 is the entry price
P 2 is the “stop loss” (output) prices
Knowing the amount of risk, and the amount of the reward, which can determine a risk-reward ratio and a large number of operations, can also determine the expected value of our trading system or strategy. This is one of the most useful, although often statistically reliable pieces of information we can get. We will learn more about this concept in our follow-up article “Hope for Mathematics in Forex.”
The above examples also assume a highly liquid at all times, which means that all orders are filled at the exact price you want. In fact, this is not always so. Your orders can or can not get slipped a little seed, creating an additional loss that may or may not be significant, depending on the size of a piece of his mind of those “few pips” you are a trader son.Si intraday the relatively large transactions in the short term positions, then a “little seed” can be added to be enough. On the other hand, if you are a swing trader or position using small positions to earn hundreds or even thousands of pips per trade, then even a few points here and there will not make a big difference in the long run. What part of the difference it makes is directly related to the average “amount of risk” your trading system or strategy. The greater the “amount of risk,” the more pain it causes slippage.
We should also mention that there are many other ways to manage risk in the foreign exchange market, including the use of currency options and other instruments as a hedge against unexpected price movements. These work slightly different and more complex and are beyond the scope of this article.
