Position Sizing Rules

When you learn the ropes as a Forex newbie, sooner or later you start wondering about advantages and disadvantages of using different position sizing techniques. This guide talks about various position sizing rules that can be used in Forex trading. It is a very important topic and your success in the foreign exchange market in great part depends from the trade sizing methods you will use. There are five main types of position sizing techniques:

Below, each of these rule systems are explained in detail.

Fixed position size

It is probably the most widely used position size type — a trader just sets a fixed lot size (for example, 1 standard lot) on all their positions. The technique is very simple to implement — both manually and in an expert advisor. It doesn't require any calculations. The problem is that it is very limited and can be quite dangerous (if the fixed size is too large).

With a fixed position size, the trader's income doesn't rise with the growth of the account balance, so the trader isn't earning profit that would be earned by employing some other position sizing models. When a trader sets their fixed position size to some large amount compared to the account balance, the risk is that the account will get wiped out in case of a continuous losing streak.

This type of position sizing can be chosen can be employed in situations when you need to trade aggressively — for example, in trading championships. Sometimes, a fixed risk is justified for a once-in-a-lifetime trading opportunity when you have carefully assessed its risk and reward potential. Otherwise, this position sizing system isn't recommended for use with a live account.

Example: Every position's volume is set to 3 standard lots.

Martingale position sizing

If you thought that fixed position sizing is dangerous, then Martingale position sizing is definitely not for you. The main rule of this technique is to increase your position size as you take losses. It is derived from the Martingale gambling system, which involves doubling your bet anytime you lose and was very popular back in the 19th century; it is still popular among some gamblers and Forex traders. This system offers a sure-fire money winning method for a trader with an infinite account balance, but, unfortunately, even George Soros' account isn't infinitely big.

In Forex, Martingale position sizing is somewhat popular partially because it offers a comfort of potential revenge on the market. A trader doubling a position size after a loss is hoping to get back what was lost and also to gain some profit at the same time. In reality, a streak of 5–6 losses in a row usually leaves the trading account empty.

Example: Using one lot as a position size, you have lost $1,000 on a trade. You increase the next position's size to two standards lots to double your potential profit (to cover your previous loss). If that one is lost too, you double the position size again to 4 standard lots, and so on.

Risk-insensitive fixed fractional position sizing

This system is often called reverse Martingale, because here a trader increases position size after a winning trade and decreases it after a losing one. The idea is to minimize the risk of ruin and to increase the income exponentially in case of a consistent profitability of the employed trading strategy.

Although it is probably the most effective and safe position sizing systems for FX trading, unfortunately, it has its disadvantages too. The biggest one is that it works poorly with trading strategies that often involve losses after huge wins — such position sizing would then increase the loss, decreasing the overall strategy's performance. The second disadvantage is a rather slow buildup of the account balance if moderate fraction ratio is used compared to some cases of fixed position sizing.

Example: Your account balance is $7,500. You decide to set your position size in lots as 0.01% of the dollar values of account. $7,500 × 0.01% = 0.75 lot. So, you set your position volume to 0.75 lot. If you win, let's say, $500, your balance increases to $8,000, and 0.01% of it will be 0.8 lot for the next trade. If you lose, let's say, also $500, your balance becomes $7,000, and 0.01% of it will be 0.7 lot for the next trade.

As you see, it is a very flexible position sizing rule because you can vary the multiplier and thus the riskiness according your preference.

ATR-based position sizing

Actually, it is just an additional rule for the fixed fractional position sizing technique (but it can be used with any of them). It involves position size normalization according to the current value of the Average True Range (ATR) indicator. The ATR shows the volatility of the market. As the ATR increases, a smaller position size would be advised because volatile market has a higher chance of pushing the trade out of its planned way. As ATR decreases, a bigger position can be opened as there is the probability of a price spike hitting your stop-loss presumably decreases too.

This position sizing add-on rule is useful in trending Forex strategies and can be harmful for range trading where spikes can be useful to hit a take-profit level.

Example: Your account balance is $10,000 and you decide to set your position size to 0.02% of the account size. You are trading EUR/USD and consider ATR = 0.00100 as a "normal value". Calculate fixed fractional position size: $10,000 × 0.02% = 2 lots. The current ATR is at 0.00221 (which means more than double "normal" volatility). Calculate ATR-adjusted position size: 2 lots / (0.00221 / 0.00100) = 0.905. So, you set your position volume to 0.905 lot (or, if your broker does not allow using one thousandth fractions of a lot, 0.91 lot). Then this position wins you $2,700. For the next position you recalculate the fixed fractional position size: $12,700 × 0.02% = 2.54 lots. The FX market is raging with volatility and ATR on EUR/USD has risen to 0.00562. Now, recalculate the ATR-adjusted position size: 2.54 lots / (0.00562 / 0.00100) = 0.452 lot (or 0.45).

This method to adjust position size is extremely adaptive but due to the extent of the required calculations is better used with the automated Forex expert advisors rather than manually.

Risk-based position sizing

The common trait of the previous four position sizing methods is that they do not control the actual risk your trade imposes on your account balance. They only change how your position size reacts to changes in your account balance and (in case of the ATR-based one) some other factors.

In reality, you want your risk per trade limited and, apparently, position size is the most suitable parameter to use for that. This is where risk-based position sizing comes from.

Risk-based position sizing is built upon the fractional position sizing. But, unlike with the risk-insensitive fixed fractional position sizing, here you would calculate the position size based on the size of the stop-loss of the particular position. The main idea with risk-based position sizing is to limit the potential loss to some fraction of the account balance based on the stop-loss.

Example: Your account balance is $12,000 and your stop-loss is set to 40 pips (normal pips), and you want to risk no more than 1.5% on your next EUR/USD trade. Calculate the maximum risk in dollars: $12,000 × 1.5% = $180. 1 pip is worth $10 on 1 standard lot of EUR/USD. Calculate the position size: $180 / (40 pips × $10) = 0.45. That is, if you want to risk no more than 1.5% on this trade with the given balance and stop-loss, you may open a position of 0.45 standard lot volume.

To easily calculate position size for risk-based method, you can use our free online Forex position size calculator.

This method is also compatible with ATR-based position sizing. However, this time, you set your stop-loss to some ATR-based value (a multiple of N-period ATR) and then calculate the position size based on this stop-loss and your risk tolerance.

Conclusion

There are also Forex traders who use no position sizing rules at all, but this isn't something a professional trader would aim for. Position sizing can help you improve the strong points of the trading strategy and decrease the chance of ruining a live trading account. If you know traders that still size their positions chaotically, you can send them a link to this guide.

If you have some questions or comments regarding the listed position sizing rules in Forex, please feel free to discuss them on our forum.


If you want to get news of the most recent updates to our guides or anything else related to Forex trading, you can subscribe to our monthly newsletter.

© 2005–2021

EarnForex.com

Design — Mart Studio

Forex trading bears intrinsic risks of loss. You must understand that Forex trading, while potentially profitable, can make you lose your money. Never trade with the money that you cannot afford to lose! Trading with leverage can wipe your account even faster.

CFDs are leveraged products and as such loses may be more than the initial invested capital. Trading in CFDs carry a high level of risk thus may not be appropriate for all investors.