Risk Management for Traders – Part Three
How Much Capital Should You Risk on Each Trade?
Most traders risk far too much on each trade when they are starting out. Successful traders risk very small amounts of capital on each trade because they know that even a trading strategy with positive expectancy can experience a string of losing trades.
A common rule of thumb is the two percent and six percent rule. This means that no more than two percent of a trading account should be risked on a single trade, and no more than six percent should be risked on all trades at any one time. Most traders risk an even smaller amount on trades with a low win rate, and around two percent on trades with a higher win rate.
Calculating the right position size for a Forex trade.
The size of a position, therefore, needs to be calculated based on the risk parameters for the particular trade (as discussed in the previous section), the size of the trading account, and the percentage of the account to be risked on each trade.
Let’s say you have $10,000 in your trading account, and you are buying GBPUSD at 1.2821 as per the example in the previous section.
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If you are risking 2% on each trade, then you are risking $200 of your $10,000 trading account. In this case, your risk is 12 pips, so your position size needs to equate 12 pips to $200.
The pip value for a standard lot is $10, so you can trade $200/12 pips x $10, or 1.67 standard lots. If you round this down to 1 lot you will be risking $120, and if you round up to 2 lots you will be risking $240.
If instead, you trade mini lots the pip value is $1, so you can trade
$200/ (12 pips x $1), or 16.67 mini lots. You can round this down to 16 mini lots which means you will actually be risking $ 192.
Calculating the position size for a CFD trade
Let’s say you have AUD 10,000 in your trading account, and you want to buy CFDs on the ASX 200 index at a price of 5,750 with a stop loss of 50 index points. If you are risking 2% of your account and each index point is worth AUD $1, then you can buy (10,000 x 0.02)/ (50 x 1), or 4 CFDs. You are simply risking AUD 50 on each CFD.
For a more complicated example, let’s imagine you are buying CFDs on the S&P500 at 2,660 with a tick size of 0.1 and a tick value of $25. Let say your stop loss is 3 index points.
In this case, you are risking 30 ticks (3/0.1) and each tick is worth $2.50, so your risk is (30 ticks x $2.50) or $75. You can, therefore, trade $200/$75, or 2.6 CFDs. If you choose to round down to 2 CFDs you be risking $150, or if you round you round up to 3 CFDs you will be risking $225.
This principle can be applied to CFDs on indices, commodities and shares.