Once you have learnt the basics of how to set a stop loss (S/L) and take profit (T/P) order correctly using a traditional risk reward ratio as your benchmark you are now able to learn how to size a position correctly taking your risk management into consideration yet allowing for enough play to survive the market noise.
If you have not learnt the basics of how to set a S/L and T/P order using a risk reward ratio please visit our previous lesson on this by clicking here.
Lets look at a trading scenario and work out our S/L and T/P order:
EURUSD is currently trading at 1.30000 and you believe that the market will be a bearish market and your target is 1.29900.
On a risk reward ratio of 3:1 your S/L and T/P orders are set at 1.30033 (S/L) and 1.29900 (T/P).
The next phase is to determine the trade size and what value of your equity you are willing to risk in order having a stab at the win? The above trade looks good on paper but we need to determine how this trade in itself fits in with your account balance, and existing risk management strategies.
ALL traders and investors must have a risk management system in place as without this you are doomed to fail. In most cases the maximal risk any trader is willing to put on any one trade is somewhere in the vicinity of 0.1-0.25% of their total equity.
We prefer a model of keeping our maximal exposure to less than 0.25% at any given time. This also includes any open trades. Apologies for the lack of formulas on this one folks, explaining it this way keeps the method simple and easy to remember.
Lets take 0.25% maximal exposure as our base, and presume our account equity is currently at $10,000. Moreover we are presuming that we have no open trades at present.
This means that we are only willing to risk a maximum of $25 on this particular trade. So we need is to be able to withstand a “stop out” of 33 pips whilst not loosing more than $25.
We then need to move on to calculate the value of a pip in order to determine what size trade to open. If you do not know or remember how to calculate a value of a pip please take the time to cover our short lesson by clicking here.
We know that the value of a pip on a full lot trade on EURUSD is $10 per pip. If we are getting “stopped out” at 33 pips it will cost us a matzo at $330 for a loss. This is a lot more than our measly 25 bucks.
Next look at 0.1 as our size, which is $1 a pip and still above our $25 exposure level if we get stopped out.
We then look at pricing our pips in the vicinity of 10c a pip, which is 0.01 lot size. If we get stopped out on this trade we are out of pocket a total of $3.30, which is well within our limit.
We are now able to work backward and potentially open a trade of at least 0.07 (take the our max risk amount and divide it by $3.30). If we open a trade of 0.07 we are 70c per pip on EURUSD, which at a risk of 33pips for this trade would cost us $23.10 if we happen to get stopped out.
The trade size we will open is 0.07.
Please note the above includes the spread you pay and not the margin required to hold the trade. This simply is a method to calculate the trade size to open allowing for your stop loss to be hit whilst still remaining well within your maximal risk exposure in dollar value.