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Showing posts with label new. Show all posts
Showing posts with label new. Show all posts
Sunday, 18 December 2016
Summary: Position Sizing
After journeying across the globe with Newbie Ned, and through some basic position sizing examples, you’re well on your way to becoming a seasoned risk manager.
Now knowing how to set the correct position sizes is only a part of what it takes to become a pro at risk management.
The other part is discipline.
Stick to your stops and pre-determined risk comfort levels and you’ll be sure to have enough after your losses to take advantage of profitable opportunities.
Finally, we know that you won’t always have a calculator handy or a position sizing feature included with your trading platform, so we here at BabyPips.com have decided to take it upon ourselves and have built a handy-dandy position sizing calculator for you!
Bam! Aren’t we cool? C’mon… Time to start a slow clap… Okay, nevermind.
Use the calculator if you need it…
Actually, use it first every single time you decide to put a trade on.
As the old adage goes, “Better be safe than sorry!”
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Complex Forex Position Sizing
In this lesson, we’ll teach you how to calculate for pairs in which your account denomination isn’t one of currencies in the pair currency pair that you wanna trade.
Account Denomination is not in the Currency Pair traded, but the same as the Conversion Pair’s Counter Currency.
Ned is back in the U.S., (we think that he’s actually a super spy just like Forex Ninja, traveling and saving the world in his free time) and today he decides to trade EUR/GBP with a 200 pip stop. To find the correct position size, we need to find the value of Ned’s risk in British Pounds.
Remember, the value of a currency pair is in the counter currency.
Okay let’s straighten things out here. He’s back trading with his U.S. broker selling EUR/GBP and he only wants to risk 1% of his USD 5,000 account, or USD 50.
To find the correct forex position size in this situation, we need the GBP/USD exchange rate. Let’s use 1.7500 and because his account is in USD, we need to invert that exchange rate to find the proper amount in British Pounds.
USD 50 * (GBP 1/USD 1.7500) = GBP 28.57
Now, we just finish the rest the same way as the other examples. Divide by the stop loss in pips:
(GBP 28.57)/(200 pips) = GBP 0.14 per pip
And finally, multiply by the known unit-to-pip value ratio:
(GBP 0.14 per pip) * [(10k units of EUR/GBP)/(GBP 1 per pip)] = approximately 1,429 units of EUR/GBP
Ned can sell no more than 1,429 units of EUR/GBP to stay within his pre-determined risk levels.
Account Denomination is not in the Currency Pair traded, but the same as the Conversion Pair’s Base Currency.
Ned decides to go snowboarding in Switzerland, and in between a couple of double black diamond runs, he opens up his trading account on his super spy phone with a local forex broker. He sees a great setup on USD/JPY, and he has decided that he will get out of the trade if it goes beyond a major resistance level–about 100 pips against him. Ned will only risk the usual 1% of his CHF 5,000 account or CHF 50.
First, we need to find the value of CHF 50 in Japanese yen, and since the account is the same denomination as the conversion pair’s base currency, all we have to do is multiply the amount risked by CHF/JPY exchange rate (85.00):
CHF 50 * (JPY 85.00/ CHF 1) = JPY 4,250
Now, we just finish the rest the same way as the other examples. Divide by the stop loss in pips:
JPY 4,250/100 pips = JPY 42.50 per pip
And finally, multiply by a known unit-to-pip value ratio:
JPY 42.50 per pip * [(100 units of USD/JPY)/(JPY 1 per pip)] = approximately 4,250 units of USD/JPY
Shabam! There you have it!
Ned can trade no more than 4,250 units of USD/JPY to keep his loss at CHF 50 or less.
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Calculating Position Sizes
To make things easier for you to understand, as usual, we’ll be explaining everything with an example.
This is Newbie Ned.
Long time ago, back when he was even more of a newbie than he is now, he blew out his account because he put on some enormous positions.
It was as if he was a gun slinging cowboy from the Midwest – he traded from the hip and traded BIG.
Ned didn’t fully understand the importance of position sizing and his account paid dearly for it.
He re-enrolled into the School of Pipsology to make sure that he understands it fully this time, and to make sure what happened to him never happens to you!
In the following examples, we’ll show you how to calculate your position size based on your account size and risk comfort level.
Your position size will also depend on whether or not your account denomination is the same as the base or quote currency.
Account Denomination the same as the Counter Currency
Newbie Ned just deposited USD 5,000 into his trading account and he is ready to start trading again. Let’s say he now uses a swing trading system that trades EUR/USD and that he risks about 200 pips per trade.
Ever since he blew out his first account, he has now sworn that he doesn’t want to risk more than 1% of his account per trade. Let’s figure how big his position size needs to be to stay within his risk comfort zone.
Using his account balance and the percentage amount he wants to risk, we can calculate the dollar amount risked.
USD 5,000 x 1% (or 0.01) = USD 50
Next we divide the amount risked by the stop to find the value per pip.
(USD 50)/(200 pips) = USD 0.25/pip
Lastly, we multiply the value per pip by a known unit/pip value ratio of EUR/USD. In this case, with 10k units (or one mini lot), each pip move is worth USD 1.
USD 0.25 per pip * [(10k units of EUR/USD)/(USD 1 per pip)] = 2,500 units of EUR/USD
So, Newbie Ned should put on 2,500 units of EUR/USD or less to stay within his risk comfort level with his current trade setup.
Pretty simple eh? But what if your account is the same as the base currency?
Account Denomination the same as Base Currency
Let’s say Ned is now chilling in the euro zone, decides to trade forex with a local broker, and deposits EUR 5,000.
Using the same trade example as before (trading EUR/USD with a 200 pip stop) what would his position size be if he only risked 1% of his account?
EUR 5,000 * 1% (or 0.01) = EUR 50
Now we have to convert this to USD because the value of a currency pair is calculated by the counter currency. Let’s say the current exchange rate for 1 EUR is $1.5000 (EUR/USD = 1.5000).
All we have to do to find the value in USD is invert the current exchange rate for EUR/USD and multiply by the amount of euros we wish to risk.
(USD 1.5000/EUR 1.0000) * EUR 50 = approx. USD 75.00
Next, divide your risk in USD by your stop loss in pips:
(USD 75.00)/(200 pips) = $0.375 a pip move.
This gives Ned the “value per pip” move with a 200 pip stop to stay within his risk comfort level.
Finally, multiply the value per pip move by the known unit-to-pip value ratio:
(USD 0.375 per pip) * [(10k units of EUR/USD)/(USD1 per pip)] = 3,750 units of EUR/USD
So, to risk EUR 50 or less on a 200 pip stop on EUR/USD, Ned’s position size can be no bigger than 3,750 units.
Still pretty simple, eh?
Well now it gets slightly more complicated.
Don’t worry though. The FX-Men got yo’ back and we’ll explain everything so it’ll become as easy as baking a cake.
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Position Sizing
Now that we’ve learned the hard lesson of trading too big, let’s get into how to correctly use leverage using proper “position sizing.”
Position sizing is setting the correct amount of units to buy or sell of currency pair.
It is one of the most crucial skills in a forex trader’s skill set.
Actually, we’ll go ahead and say it is THE most important skill.
Traders are “risk managers” first and foremost, so before you start trading real money you should be able to do basic position size calculations in your sleep… or at least after you wake up, still groggy, and try to trade the NFP report!
Finding the position size that will keep you within your risk comfort level is relatively easy…and we use the phrase “relatively easy” loosely here. Besides, if Pipcrawler, who can’t tell his pinkies from his toes, can do it, then you can too!
Depending on the currency pair you are trading and your account denomination (is your account in dollars, euros, pounds, etc??), a step or two needs to be added to the calculation.
Now, before we can get our math on, we need five pieces of information:
- Account equity or balance
- Currency pair you are trading
- The percent of your account you wish to risk
- Stop loss in pips
- Conversion currency pair exchange rates
Easy enough right? Let’s move on to a few examples.
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Saturday, 17 December 2016
Never Underestimate Leverage
Most beginners underestimate the potentially devastating damage leverage can wreak on their accounts. Understanding leverage enough to know when to use it and when NOT to use it is critical to your success!
Leverage is a very powerful tool but both old and new traders use it to destroy their trading capital simply because they take its destructive force too lightly or ignore it altogether. It’s a pity, but the more of them there are, the easier it is for us smart traders to make money. Sad but true.
Always keep in mind these words from a famous superhero: With great power comes great responsibility. Or something to that effect. Come on, we know you’ve seen that movie. Here’s a clue:
Get it?
Anyway, high leverage is a favorite selling point for most forex brokers. Yes they pitch that you can make a huge killing using huge leverage, but also know that you could easily be killed by huge leverage as well.
Brokers want you to trade with a short-term mindset. They want you to trade as much as possible as often as possible. It’s the only way they make money. One or two pips are important to them. The more you trade the more they make on the spread. It’s not in their best interest to tell you to let your trades run longer than the same day.
If you want to give yourself the best chance to succeed, first learn to trade profitably without leverage.
Play it safe. Protect your capital.
When you can consistently make more pips more than you lose then, and only then, should you use unleash this weapon of mass destruction called leverage.
Destroy traders (or your broker) taking the opposite side of your trade. Don’t destroy yourself.
Forex trading should be treated as a job or business. Don’t think that just because brokers allow you to use high leverage with a low minimum deposit that you can “make a quick ” or “get rich quick”. Approach the currency markets with respect.
Be realistic in your expectations and be willing to properly educate yourself.
If you don’t, you will die.
Okay, not really, but your account will die.
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How Leverage Affects Transaction Costs
Besides amplifying your losses, leverage also has another way of killing you. It’s a much slower kind of death though, kinda like dying by a thousand cuts.
Most forex traders don’t see it coming and by the time they notice it, they’re DEAD.
This killer I’m talking about is the associated transaction costs of using high leverage.
Not only does leverage amplify your losses, it also amplifies your transaction costs as a percentage of your account.
Let’s say you open a mini account with $500. You buy five mini $10k lots of GBP/USD which has a 5 pip spread. Your true leverage is 100:1 ($50,000 total mini lots / $500 account).
But check this….you paid $25 in transaction costs (($1/pip x 5 pip spread) x 5 lots)).
That is 5% of your account!
With one trade, and the market not even moving yet, you’re already down 5%! If your trades lose, your account balance shrinks.
As your account balance shrinks, your leverage increases. As your leverage increases, the faster your transaction costs eat away at the little money you have left.
This is the slow and silent killer I’m talking about.
The higher your leverage, the higher your transaction cost as a percentage of your trading capital.
This is why transactions costs is one of the six most important factors when choosing a broker.
If you have a mini account, and open a trade with a 5-pip spread, which equals $5 transaction cost, look at how the relative value of your transaction costs increases with more leverage.
| Leverage | Margin Required | Cost as % of Margin Required |
|---|---|---|
| 200:1 | $50 | 10.00% |
| 100:1 | $100 | 5.00% |
| 50:1 | $200 | 2.50% |
| 33:1 | $330 | 1.50% |
| 20:1 | $500 | 1.00% |
| 10:1 | $1,000 | 0.50% |
| 5:1 | $2,000 | 0.25% |
| 3:1 | $3,300 | 0.10% |
| 1:1 | $10,000 | 0.05% |
Now you’ve learned how leverage can magnify your profits and losses, but also your transaction costs.
Leverage does not equal margin.
Leverage is how many times you lever your whole account.
The maximum amount that you are allowed to lever is dependent on your margin requirement.
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Low Leverage Allows New Forex Traders To Survive
Here’s a chart of how much your account balance changes if prices moves depending on your leverage.
| Leverage | % Change in Currency Pair | % Change in Account |
|---|---|---|
| 100:1 | 1% | 100% |
| 50:1 | 1% | 50% |
| 33:1 | 1% | 33% |
| 20:1 | 1% | 20% |
| 10:1 | 1% | 10% |
| 5:1 | 1% | 5% |
| 3:1 | 1% | 3% |
| 1:1 | 1% | 1% |
Let’s say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20. If you trade one standard $100K lot, here is how leverage would affect your return:
| Leverage | Margin Required | % Change in Account |
|---|---|---|
| 100:1 | $1,000 | +100% |
| 50:1 | $2,000 | +50% |
| 33:1 | $3,000 | +33% |
| 20:1 | $5,000 | +20% |
| 10:1 | $10,000 | +10% |
| 5:1 | $20,000 | +5% |
| 3:1 | $33,000 | +3% |
| 1:1 | $100,000 | +1% |
Let’s say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80. If you trade one standard $100K lot, here is how leverage would affect your return (or loss):
| Leverage | Margin Required | % Change in Account |
|---|---|---|
| 100:1 | $1,000 | -100% |
| 50:1 | $2,000 | -50% |
| 33:1 | $3,000 | -33% |
| 20:1 | $5,000 | -20% |
| 10:1 | $10,000 | -10% |
| 5:1 | $20,000 | -5% |
| 3:1 | $33,000 | -3% |
| 1:1 | $100,000 | -1% |
The more leverage you use, the less “breathing room” you have for the market to move before a margin call.
You’re probably thinking, “I’m a day trader, I don’t need no stinkin’ breathing room. I only use 20-30 pip stop losses.”
Okay, let’s take a look:
Example #1
You open a mini account with $500 which trades $10K mini lots and only requires .5% margin.
You buy 2 mini lots of EUR/USD. Your true leverage is 40:1 ($20,000 / $500). You place a 30-pip stop loss and it gets triggered. Your loss is $60 ($1/pip x 2 lots).
You’ve just lost 12% of your account ($60 loss / $500 account). Your account balance is now $440.
You believe you just had a bad day. The next day, you’re feeling good and want to recoup yesterday losses, so you decide to double up and you buy 4 mini lots of EUR/USD. Your true leverage is about 90:1 ($40,000 / $440). You set your usual 30-pip stop loss and your trade loses. Your loss is $120 ($1/pip x 4 lots).
You’ve just lost 27% of your account ($120 loss/ $440 account). Your account balance is now $320.
You believe the tide will turn so you trade again. You buy 2 mini lots of EUR/USD. Your true leverage is about 63:1. You set your usual 30 pip stop loss and lose once again! Your loss is $60 ($1/pip x 2 lots).
You’ve just lost almost 19% of your account ($60 loss / $320 account). Your account balance is now $260.
You’re getting frustrated. You try to think what you’re doing wrong. You think your setting your stops too tight.
The next day you buy 3 mini lots of EUR/USD. Your true leverage is 115:1 ($30,000 / $260). You loosen your stop loss to 50 pips. The trade starts going against you and it looks like you’re about to get stopped out yet again!
But what happens next is even worse! You get a margin call!
Since you opened 3 lots with a $260 account, your Used Margin was $150 so your Usable Margin was a measly $110. The trade went against you 37 pips and because you had 3 lots opened, you get a margin call. Your position has been liquidated at market price.
The only money you have left in your account is $150, the Used Margin that was returned to you after the margin call.
After four total trades, your trading account has gone from $500 to $150. A 70% loss! It won’t be very long until you lose the rest.
| Trade # | Starting Account Balance | # Lots of Used | Stop Loss (pips) | Trade Result | Ending Account Balance |
|---|---|---|---|---|---|
| 1 | $500 | 2 | 30 | -$60 | $440 |
| 2 | $440 | 4 | 30 | -$120 | $320 |
| 3 | $320 | 2 | 30 | -$60 | $260 |
| 4 | $260 | 3 | 50 | Margin Call | $150 |
A four trade losing streak is not uncommon. Experienced traders have similar or even longer streaks. The reason they’re successful is because they use low leverage. Most cap their leverage at 5:1 but rarely go that high and stay around 3:1.
The other reason experienced traders succeed is because their accounts are properly capitalized!
While learning technical analysis, fundamental analysis, sentiment analysis, building a system, trading psychology are important, we believe the biggest factor on whether you succeed as a forex trader is making sure you capitalize your account sufficiently and trade that capital with smart leverage.
Your chances of becoming successful are greatly reduced below a minimum starting capital. It becomes impossible to mitigate the effects of leverage on too small an account.
Low leverage with proper capitalization allows you to realize losses that are very small which not only lets you sleep at night, but allows you to trade another day.
Example #2
Bill opens a $5,000 account trading $100,000 lots. He is trading with 20:1 leverage. The currency pairs that he normally trades moves anywhere from 70 to 200 pips on a daily basis. In order to protect himself, he uses tight 30 pip stops. If prices goes 30 pips against him, he will be stopped out for a loss of $300.00. Bill feels that 30 pips is reasonable but he underestimates how volatile the market is and finds himself being stopped out frequently.
After being stopped out four times, Bill has had enough. He decides to give himself a little more room, handle the swings, and increases his stop to 100 pips.
Bill’s leverage is no longer 20:1. His account is down to $3,800 (because of his four losses at $300 each) and he’s still trading one $100,000 lot. His leverage is now over 26:1.
He decides to tighten his stops to 50 pips. He opens another trade using two lots and two hours later his 50 pip stop loss is hit and he losses $1,000. He now has $2,800 in his account. His leverage is over 35:1.
He tries again with two lots. This time the market goes up 10 pips. He cashes out with a $200 profit. His account grows slightly to $3,000.
He opens another position with two lots. The market drops 50 points and he gets out. Now he has $2,000 left.
He thinks “What the hell” and opens another position. The market proceeds to drop another 100 pips and because he has $1,000 locked up as margin deposit, he only has $1,000 margin available, so he receives a margin call and his position is instantly liquidated.
He now has $1,000 left which is not even enough to open a new position.
He lost $4,000 or 80% of his account with a total of 8 trades and the market has only moved 280 pips. 280 pips! The market moves 280 pips pretty darn easy.
Are you starting to see why leverage is the top killer of forex traders?
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