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How to Find Out the Right Position Sizing

The Forex market is the biggest financial market in the world and every day trillions of dollars are changing hands. From retail traders to institutional investors, from commercial to central banks, all parties are contributing to the currency market volatility.

Volatility is the reason for market moves and market moves are the reason why retail traders (and not only) are interested in the Forex market. That is, to speculate.

The art of speculation is not for everyone as it requires more than technical and/or fundamental knowledge. Trading is not straightforward and the market is not moving one way or another just because an economic release indicated that or because a monetary policy change suggests that.

The moves the market makes are subject to a lot of factors, starting with supply and demand and ending with the broker that executes the orders. As such, there is a thin line between trading the Forex market and consistently beating it.

Profitable speculation is more than looking at an overbought or oversold level and taking a position. It is mostly about that, but on top of it, add market psychology, human nature, money management, and much, much more.

An important part of a money management system is position sizing. One can be profitable ten or a hundred times in a row, and be wrong only once, and lose all the money in the trading account.

This can happen if the position sizing was not appropriate. Defense is better than attack in Forex market and the aim is to survive long enough to fight the battle for another day.

If you can do that, chances to make a profit increase dramatically. At this point, the real opportunities offered by this amazing market will open themselves.

The Right Position Sizing

Position sizing refers to the ability to find the right volume to be traded at any one moment of time. In other words, if you are to open a new trade, long or short, what is the right volume for that trade?

How many lots or fractional lots to be traded? Too many means too risky, a lower volume may not be enough for a sizable profit to justify the effort put in the analysis.

Therefore, a balance must be found. This is not an easy task as it may look at the first glance, but part of a planning process that will end up defining the overall money management system.

Proportional Sizing

The classical way to the right position sizing is to risk only a small proportion of the trading account on any given trade. This is what everyone recommends and, in earnest, it is the right thing to do.

Conservative traders are risking only one percent of their balance (equity should be used here, not the actual balance in a trading account, as the equity reflects the current value of a trading account while the balance is referring to the potential one). If you read what's in the brackets, you already know why most of the traders fail to correctly position for a new trade.

They apply the percentage to the balance of a trading account, which is dead wrong, as it doesn’t reflect the reality. This is the one thing that goes wrong.

Another one is that there is not a clear line between how much is too much and how much is not. I’m talking about the percentage to be risked on any given trade.

While one percent is too conservative, five is too much. A fine balance would be around two or two-point-five percent to be risked on a trade.

This percentage approach to position sizing keeps emotions at the fence as the next step is known in advance. If equity increases (which is the reason why traders are involved in this market in the first place), the next trade will reflect that with a bigger position sizing.

Downsizing is important too! If traders are not able to downsize after a losing streak, the road to ruining the trading account starts at that moment.

Avoid Correlations

Believe it or not, currency pairs are correlated more than traders like to believe. Sometimes correlations are so strong that it doesn't make any sense to trade more than a currency pair that involves the driving currency.

The perfect example comes from the U.S. dollar related pairs. These are being called major pairs as they have the world's reserve currency in their componence.

If the driving factor in a major pair is the U.S. dollar, say, the dollar is appreciating because the Federal Reserve (the United States central bank) raised the interest rate, then all the majors will move in the same direction like any dollar related pair.

Following up, it means that the EURUSD, GBPUSD, AUDUSD, NZDUSD will move to the downside, while USDCAD, USDJPY, and USDCHF to the upside. In the first instance, shorts should be traded and longs in the second one.

So far so good. The problem comes when executing the plan. According to the proportional position sizing, we should risk one percentage of the equity in a trading account on any given trade.

However, if we take one short on EURUSD, one on GBPUSD, one on AUDUSD and one on the NZDUSD pair as well, we'll end up trading four times the risk. This is because all those trades are correlated.

The way to avoid correlations is to simply not trade in the same direction at the same moment of time. Wait for time to confirm a move, as not all currency pairs start a move at the same time.

This is a classic rookie mistake among retail traders. Even if it is a basic rule, many fail to understand that position sizing is not only proportional trading but much more than that.

Other correlated trades are between oil and the USDCAD pair (CAD is heavily correlated with the oil market), or between U.S. equity markets and the JPY pairs. Knowing how correlations work is a great step forward in finding the right position sizing for a future trade.

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