Risk Management Talking Points:
- Trade size is an important factor of risk management
- Larger lots increase profits and losses per pip
- Use a simple ‘cost per pip’ formula to identify your position size
One of the important steps when day trading, is deciding how big your position should be. Position size is a function of leverage and while trading a large position may multiply a win, it can exponentially increase the value of a potential loss. This is why traders should always consider position size in trading. If too much leverage is incorporated in any given position, there could be unnecessarily devastating affects to one’s account balance. To help, today we will review how to determine the correct lot size for your trading.
Determine Your Risk
Before you can select an appropriate lot size, you need to determine your risk in terms of percentages. Normally, it is suggested that traders use the 1% rule. This means in the event that a trade is closed out for a loss, no more that 1% of the total account balance should be at risk. For example, if your account balance totals $10,000, you should never risk losing more than $100 on any position. The math is fairly self-explanatory, and you will find the basic equation used below. Once you have a risk percentage in mind, we can move to the next step in determining an appropriate position size.
Find Your Stop
As with any open position, a stop should be set to determine where a trader wishes to exit a trade in the event the market moves against them. There are virtually countless ways stops can be placed. Normally traders will use key lines of support and resistance for order placements. Traders can use price action, pivots, Fibonacci, or other methods for finding these values. The idea is with whatever method you decide, count the number of pips from your open price to your stop order. Keep this value in mind as we move to the last step of the process.
Pip Cost & Lot Size
The last step in determining lot size, is to determine the pip cost for your trade. Pip cost is how much you will gain, or lose per pip. As your lot size increases, so does your pip cost. Conversely if you trade a smaller lot size, your profit or loss per pip will decrease as well. Which leaves the final question, how big should your trade size be?
First, take your total trade risk (1% of your account balance), and then divide that calculated value out by the number of pips you are risking to your stop order. The total at this point is the amount per pip you should be risking. In the example above, if you are placing a trade on a $10,000 account you should only be risking about $100. On a 10 pip stop, this equates to a risk of $10 a pip. On pairs like the EURUSD, this means trading a 100k lot!
Most traders are right on a majority of their trades, yet their trading account is unprofitable over time. We've researched and answered this phenomenon on page 5 of our traits of a successful trader guide.
---Written by Walker England, Trading Instructor