Trading 101: Risk Management for Traders
Losing capital slowly over a long period of time is usually the result of a poor trading system or excessive trading costs. Losing capital quickly results from risking too much capital on individual trades or poor discipline.
Risk management should, therefore, be a part of every stage of the trading system, including system or strategy design, position sizing and execution.
Calculating Position Size and Exposure
It’s impossible to manage risk if you do not know how big a position is or how much you are risking. Being able to calculate the exposure and risk for each trade is, therefore, the first thing to do before opening a position. While this may seem obvious, many people who are new to trading don’t know how big their trades actually are.
If you are trading shares, calculating the size of a position is very straight forward:
Position size in USD = Share Price in USD x Number of shares
For Forex and margined products like CFDs and futures, calculating the size of a position is slightly different. Remember, your market exposure is equal to the position size, not the margin required for a trade.
For both Forex and CFDs, if you know the tick value, you can calculate the position size from that. Let’s take a look at CFDs first.
Position Size for CFD Trading
Let’s say you buy 1 CFD on the ASX 200 at an index level of 5,750 and one point is equal to 1 AUD. This means you will make 1 AUD for every point the index rises and lose 1 AUD for every point the index falls.
In this case, if the index rose 100%, the profit would be AUD 5,750, so 100% of the position is AUD 5,750 which is the total position size.
If the one point was worth AUD 10, then the position size for one CFD would be AUD 57,500. If one point was worth AUD 25, then the exposure for one CFD would be 5,750 x 25, or AUD 143,750.
In some cases, the minimum tick size is measured in movements that occur to the right of the decimal place. For example, the minimum tick value for CFDs on the S&P500 is often 0.1 points or 0.01 points.
If the S&P500 is trading at 2,660 and the tick size is 0.1, with a tick value of $1, then one CFD is worth 2,660 x10 x $1, or $26,660.
If the tick size was 0.01 and a tick was worth $1, then one CFD would be worth 2,660 x 100 x $1, or $266,600. That may seem very high, but in reality, one tick is often worth only $0.1 or $0.01.
Position Size for Forex Trading
Calculating your exposure for a Forex trade is similar. The tick size is known as a pip, and for most currency pairs it is the fourth number after the decimal point. The exception is the Japanese Yen (JPY) for which the pip value is the second number after the decimal point.
If the GBPUSD pair is trading at 1.2821 and the price rises to 1.2822, it has risen by one pip. But how much is a pip worth, and what is the total value of a position?
For Forex, this depends on the contract size you are trading. Currencies are usually traded in lots. A standard lot is 100,000 units of the base currency, which is the first currency in the quote – i.e. GBP in the case of the GBPUSD pair. So, a standard lot for this pair would be GBP 100,000 which would be worth USD 128,210.
Fortunately, you can also trade mini lots which are 10,000 units and even micro-lots which are 1,000 units. In the above example, a mini lot would be worth USD 12,821 and a micro lot would be worth USD 1,282.10.
For a standard lot, the pip value is $10, for a mini lot it is $1 and for a micro lot, it’s $0.1.