David Waring

So far in the lessons leading up to this one we have covered some of the different methods traders use to pick their entry points, as well as some of the different methods which traders use to set their exit points. In this lesson we are going to look at the factor which ties all of the above together and allows a trader the greatest control over their returns: Position Sizing.

While position sizing is one of the Key components of successful trading, like many of the other things we have covered, it is often overlooked as an unimportant aspect of trading. What successful traders know however is that once the psychology of trading is mastered and a trader has developed a sound strategy for picking their entry and exit points, it is the method they use to determine the size of the positions they trade that is the final factor which will lead to their success or failure.

To help illustrate this lets say that three traders are each given $10,000 and the same EUR/USD Mini Forex strategy to trade which has a win rate of 60% (makes a profit on 6 out of 10 trades) and makes an average profit on winning trades over the long term of 100 Points. On the losing side, this same system has a lose rate of 40% (takes a loss on 4 out of 10 trades) and takes an average loss on those trades of 90 points.

So here we have a trading strategy that has more winning trades on average than it does losing trades, as well as a strategy that when it does lose it loses less than what it does when it wins. I think most traders including myself would take that system any day of the week.

So we give these traders each this system and tell them to come back to us after 10 trades and show their results. As the system is the same for all traders, when they bring us back the trading results of their systems the entry points and exit points for each trade is going to be the same, leaving them only the position size as the factor that they can tweak.

As they are trading mini EUR/USD forex contracts the value of a 1 point move is $1 per contract traded. With this in mind after 10 trades the system produces the following results:


So Trader 1 recently read an interview of a successful trader who said that one of the major reasons why forex trading has such a bad name is that people over leverage themselves. In this interview the trader recommended not leveraging more than 20 to 1. So with this in mind the trader decides that since this is a winning system he is going to take it to the max that this trader recommended and trade 5 mini forex contracts (50,000) on each trade since he is starting with $10,000.

With this in mind his results are the following:


Trader 2 decides that since the strategy is one of the best he has seen he is going to be more aggressive than trader 1 and trade 10 contracts (100,000) on each trade. This produces the following results.


As you can see here by doubling the number of contracts that he traded on each trade trader 2 doubled the returns of trader 1.

Trader 3 decides that since the system is a guaranteed winner he is going to leverage up as much as he can and swing for the fences on every trade thinking that this will produce the maximum gain at the end of the 10 Trades. This produces the following results.


As you can see here because he had such a large trade on and the first trade was a loser, he now had very little money left after the first trade and therefore could not trade as many contracts. Continuing with the strategy though the trader kept swinging for the fences on every trade until he was basically at the point where he did not have enough money in his account to initiate a new position for the 9th and 10th trades.

As I hope the above examples of three traders given the same strategy can produce drastically different results based on the position size they take with each trade, and thus shows the importance that position sizing plays in any successful strategy. In tomorrow’s lesson we are going to look at some of the different strategies many traders use to determine their position size so we hope to see you in that lesson.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together, and good luck with your trading!

Position Sizing External Links:

Position Sizing By Trader Mike

An Article on Position Sizing by Dr. Van K. Tharp

An Academic Study on Position Sizing

kawola17

Hello Dave,

Thanks for including the study on position sizing. Definitely an eye-opening study. Wow.

There's so much hype or emphasis on pattern strategies, timing, getting a feel for the market, etc. that position sizing gets so easily overlooked. It's so interesting to see people get so wrapped up into their systems, when in fact that one of the greatest key to success is NOT their system but position sizing. (Not to say a successful system would definitely help).

It is so interesting how success can boil down to something so fundamental. (I'm sure with many other things in life as well).

Thanks again.

Sincerely,
Bill

prolog

As I'm a beginner, I don't understand the concept of "contract"

Tekmnd

"As I'm a beginner, I don't understand the concept of "contract"'

A contract is a futures contract. 2 people enter a contract; one person agrees to buy, and one person agrees to sell, a certain commodity at a particular price.

I'll give an example: Right now gold is about $820 an ounce. If you thought gold was going up again, you might enter a contract to buy gold at $850 an ounce that expires in March. Let's say between now and March, gold climbs to $950. In March, you get to buy gold at $850 and sell at $950, making $100 an ounce.

If you thought gold was going down, you might enter a contract to sell gold at $800 an ounce in March. If gold hits $700 between now and March, you get to buy gold at $700 and resell it at $800, making $100 an ounce.

The reason you enter a contract, verses just buying gold at $820 and holding it until it goes up, is that with a contract, you don't have to put the entire $820 an ounce down. You put up what might be referred to as a deposit (a small percentage down). This allows you to take advantage of leverage, and frees up your trading cash for other investments.

I tried to do a simple explanation. Hope it makes sense
Cheers
Tek

prolog

thanks

But I don't understand this part.

how about 'contract' in the above context in forex?

I don't understand the following statement








I understand leverage. But what is the relationship between 20:1 leverage and 5 mini forex contracts?

what is 50,000?

prolog

What is 'position'? Is it the number of contracts?



I'm confused between leverage and contract.


Sorry
I'm just an Engineering Degree holder.


I think I need some numerical breakdown

Tekmnd

Hi again prolog

I've been doing stocks for awhile, but I am still very new to forex myself.

Forex is traded in contracts. Each contract is for a certain amount of currency. There are 3 types-
A regular contract is for 100,000 of the base currency (If base currency is the US dollar, it means each contract is for $100,000)
A mini contract is for $10K
A micro contract is for $1000

This means if you buy 5 mini contracts of a currency pair, you have bought $50K worth of the base currency. If the base currency is the US dollar, you bought $50K worth. In the Euro/dollar pair, you bought $50,000 Euros worth. Pretend the base currency is the US dollar for the rest of this explanation to make it easier.

Because the exchange rate between two currencies usually does not change more than a percent each day, people trade on leverage. I'll give an example to explain-

You have $10,000 to invest in forex. If you buy 1 mini contract for $10K, most days it is only going to go up or down $100 or less in value each day. In addition, it could be ranging, so 1 day it goes up $50, the next it goes down $50. Not very exciting for a $10K investment.

However, when you trade on leverage, you put down only a small amount of cash to hold the contract (similar to a deposit). For instance, you can open an account with only $1000 and still buy a $10K contract. Therefore, the $50 a day or so it goes up and down each day is a bigger percentage of your investment.

With your $10K account, if you only buy 1 mini contract, you are using 1 to 1 leverage (you are using $10K to trade $10K worth of currency). If you buy 2, you are using 2 to 1 leverage (you are using $10K to trade $20K worth of currency). If you buy 10, you are using 10:1 leverage.

You are giving access to much more leverage than you should use. For instance, you can trade $10K worth of currency using only $100 (100:1 leverage) "deposit."
Each day the $10K will go up and down $50-$100, so your $100 investment each day could either double or go to $0. You choose the level of leverage you want to trade with.

I hope this part makes sense. It confused me a bit at first as well, but it is really pretty simple; you are using leverage to take small moves in the exchange rates and turning them into larger profits and/or losses.

______________

I am assuming you know what a pip is. When the price of a currency pair is quoted, and the base currency is the us dollar, each pip change in the price is 1/100th of 1 cent per dollar.
So if the price goes up 1 pip, each contract went up 1/100th of a penny per dollar in the contract.

A regular contract is $100,000, so each time the price changes 1 pip, the contract value goes up or down (profit/loss) $10. So if you own a contract, and the price goes up 20 pips, you made $200.

A mini contract is $10K, so each pip change in price means the value of this contract went up or down $1

A micro contract is only $1000 worth of currency, so each pip change in price is 10 cents. So if you own a micro contract, and it goes up 20 pips, you made two bucks.

___________________
"But what is the relationship between 20:1 leverage and 5 mini forex contracts?"
"5 mini forex contracts (50,000) "
"the value of a 1 point move is $1 per contract traded. "

I hope I answered this already, but I will explain specifics on this-
If you buy 5 mini contracts, you have bought $50K worth of currency. If you did so on 20:1 leverage, it means you only put down $2,500 to do so (you don't really "put it down"; it means $2500 of your account is on hold while you own this contract).
Since each pip is 1/100th of a penny, each time the exchange rate goes up and down a pip, the value of 5 contracts goes up or down $5 ($1 per contract).
_____________________

I will also add that if you are not aware, you can trade using a virtual account. It works just like a real account, but you "paper trade" (trade with fake money until you learn, so you are not risking anything). FXCM is a place you can do that (FXCM.com)

Also, if I made sense in my very long, rambling on and on explanation lol, then you also may have realized that you can open a micro account with very little money (you can open it with as little as $25, but really you need at least a couple hundred bucks to start), and trade 1 or 2 contracts. With only 1-2 contracts, your account is only going to go up or down $5-$20 a day. I opened mine 2 weeks ago, and I love it. I day trade at work and annoy the guy next to me by going "I just made 40 cents!! WOOHOO!!" all day long lol.

Cheers
Tek

prolog

I don't know how to thank you Tekmnd

Very well explained.




I'm now crystal clear

silverpuma

Hi Tek, Fantastic!! What a wonderful, clear explanation. And even more impressive is the patience you exhibit with us newbies. I'm going to print your "manual" out and have it for some bedtime reading.

To the micro account I go.

Take care,

George

Tekmnd

Hi George

Thanks
Remember to follow good money mangement with the micro account. In fact, the micro account is great for teaching discipline, because it tempts you to over trade.

I just upgraded my account to mini lots (standard FXCM account with $10K lots) a week ago, so it is taking a little adjusting getting used to going up and down $1 a pip instead of 10 cents.

Cheers
Tek