Given the high volatility that every investor is going to face in the market, knowledge of risk management is absolutely necessary. Position sizing can be turned into several interesting money management strategies that can help you.
Risk is an inseparable part of every business. Normally, we will go ahead and say that having the right risk management system is the most important component of a business. Essentially, risk management is about risk control, and a good risk management strategy will assist us to reduce the risk as low as possible while still gaining maximum return.
Over the years, numerous investors have been researching and implementing various strategies of the risk management system. Each strategy has its own respective strengths and weaknesses, so there is yet a particular perfect method or strategy that is the most appropriate for everyone. Especially in forex trading where the risk factors tend to be very high, risk management may not be as simple as we imagine. One of the most implemented risk management strategies used in the forex market is Position Sizing.
Position Sizing refers to the number of units invested in a particular currency by an investor or trader. Investors use position sizing to assist them to determine how many units of currency they can buy, which in turn helps them to control risk and maximize returns.
See also: 5 Key Tips on Money Management
In Position Sizing, rather than placing an order by gut feeling, the investor will need to calculate the size of a position (a lot, volume, or quantity) within a particular portfolio, or the cash amount that an investor is going to trade.
Correct Position Sizing is the number of units of a transaction based on the capital we have, the maximum risk that we are prepared to bear, and the risk of possible transactions. Thus, for every transaction, the correct Position Sizing will be neither too much nor too little.
There are a few approaches in the Position Sizing strategy that we can use. This article will review the advantages and disadvantages of each of those strategies.
1. Martingale Strategy
In the 18th century, a French mathematician named Paul Pierre Levy developed a strategy for gambling which turned out to have a fairly high winning rate. The trick is to multiply the bet value every time we lose our bet. The idea is, we only need one win to cover all losses.
On paper, this strategy is very convincing, but in practice, it might cause our money to run out faster. The problem appears when successive losses occurring, in which our capital may run out before we experience a single win.
When translated into forex trading, martingale strategy can be run by increasing the risk for the next trade every time we experience a loss; that is to adjust its position size (lot size, volume, or quantity). The risk/reward of this strategy tends to apply a 1: 1 ratio because in essence, this method is trying to cover losses as quickly as possible. Thus, the amount of risk is 50% of our portfolio. This will cause a drawdown or a high percentage of losses.
The following is an example of a martingale strategy that can work effectively: Assuming our initial balance is $100, risk/reward ratio = 1:1, the initial risk is $1,0 and we will multiply it every time we experience a loss.
- We earn a profit on our first trade (win) so the balance increases to $110.
- With the same conditions on the 2nd trade, we lose so the balance returns to $100.
- By using the Martingale strategy, on the 3rd trade, our risk increases two-fold: 2 x $10 = $20.
- The risk/reward ratio stays at 1:1. It turns out that we lost again so the balance is reduced by $20 to $80.
- In the 4th trade, we double-up the risk value again to be: 2 x $20 = $40.
- We get profit from winning, so our balance increases by $40 to $120.
The next example is trading with a Martingale strategy that ended in tragedy. The initial balance assumption, risk/reward ratio, and the amount of risk are the same as the previous example.
- We lose in the first trade so the balance becomes $90.
- With a risk of $20, the 2nd trade also loses and our balance shrinks again to $70.
- On the 3rd trade, our risk is $40. But as we lose again in the 3rd trade, we are left with $30 now.
- To adjust the position size with risk calculations 2 x $ 40 = $80.
- Our leftover balance is $ 30, and thus, the leftover balance is not sufficient to adjust the position size.
- For simulation purposes, we bet the last remaining balance of $30.
- It turns out to be a loss too, so the account loses all the money a.k.a game over.
As we see in the last example, it only takes 4 trades to drain our funds. Therefore, many trading coaches recommend avoiding using this strategy, especially for beginners. The main reason is that in determining the risk amount, this martingale system uses an exponential pattern.
On the other side, the anti-martingale strategy is safer and far from risk. However, this strategy has some important notes for traders before implementing it.
2. Anti-Martingale Strategy
As the name suggests, this strategy is the opposite of the martingale strategy. In this anti-martingale strategy, we don't double the risk every time after experiencing a loss, but only double the risk every time we profit. The creator of this strategy must have felt the bitterness of trading with the martingale strategy so he's inspired to "let profits continue to increase and realize losses as early as possible". This principle is an excerpt from an English term that reads: "let your profits run and cut your losses short".
However, there are important notes in implementing this strategy:
1. By doubling the risk each time after making a profit, the probability of suffering a bigger loss will also be higher. Therefore, we must use a risk/reward ratio greater than 1:1. From the results of trials and errors, it is recommended to apply a ratio of 1:2. This is to prevent the consequences of consecutive losses that occur after we profit several times, which causes the risk value to swell.
An example of a risk multiplying system every time after profit with a risk/reward ratio of 1:2, the initial balance is $ 100:
2. To minimize the risk after experiencing a loss, the position size is reduced by half, or the risk is reduced by 50% each time after experiencing a loss. This is also to avoid a large drawdown after a losing streak. Here's an example of applying the anti-martingale strategy that has had 4 consecutive profits and 3 consecutive losses. risk/reward Ratio is 1:2, with an initial balance of $100.
As shown in the table above, we double our risk every time we experience a profit. As a result, the final balance was $400.
Then when there are 3 consecutive losses, the accumulation is as follows:
By minimizing the risk by 50% every time you lose, your account can still survive and gain profit despite successive losses. If we do not reduce the position size, our account will be exposed to Margin Call.
The following is an example of an anti-martingale strategy for trades that experience alternating profits and losses. The risk/reward ratio us 1:2, and the initial balance is $100.
In the subsequent developments, the risk/reward ratio does not have to be exactly 1:2, but rather flexible according to market conditions. As long as it is higher than 1:1, we can still maintain good profitability. For example, you choose a risk/reward ratio of 1:1.5 because the market is moving sideways or the price is moving in a narrow range. In a situation like this, it is natural to minimize the profit target, because the price movement is unlikely to jump significantly to touch a big profit target.
Likewise, a decrease in position size (lot size, volume, or quantity) after experiencing a loss does not have to be reduced by half (50%). This rule tends to be flexible according to the balance condition in your account. If you are a conservative trader, you can reduce the position size by more than half.
Conversely, aggressive traders can reduce the trade size by less than half. Whatever amount of reduction you choose later, try to keep the percentage reduction consistent.
Anti-Martingale Vs Martingale
As seen in the example above, the anti-martingale strategy is much safer and more profitable than the martingale strategy. This is due to a risk/reward ratio greater than 1:1 and a decrease in risk (by reducing position size) every time after experiencing a loss. Thus, the amount of risk does not increase exponentially as in the martingale strategy, which can result in a very large drawdown.
Other than martingale and anti-martingale, this article will also discuss fixed position sizing, scaling in, and scaling out.
3. Fixed Fractional Position Sizing
Fixed Fractional Position Size Strategy is also widely known as the 2% rule. This is because in this money management system, professional traders usually only dare to take a maximum risk of 2% for every trade. This way, the investor's risk will still be proportional to their tolerance even if there is a losing streak. In other words, they don't experience big drawdowns. To implement this method, you must determine the amount of risk per trade in terms of money value before converting it into the lot size or trading volume.
Suppose the balance in your account is $500. If you set your risk per trade at 2%, this means that the maximum loss you will incur per trade is:
2% x $500 = $10
$10 / 40 = $0.25
This makes your trading lot size:
$0.25 / $1 = 0.25 lot
If you are trading in micro lots where the value per pip is $0.1, your trading lot size will be:
$0.25 / $0.1 = 2.5 lots
Many traders combine this 2% fixed position sizing with an anti-martingale strategy to get optimal trading results. As in the anti-martingale strategy, when you lose, the risk is reduced by 50%. Meanwhile, when it is profitable, the risk is increased by 2 times for the next trade. However, in increasing the risk, you still need to keep in mind that the maximum amount of risk in the money value can't exceed 2% of your balance.
4. Scaling In
The main goal of the money management strategy is to find a method that can make the smallest loss amount while optimizing the profit. It doesn't matter how many times a trader gains or loses, the most important matters is how much an investor gains when he gains and how much he loses when he loses. So, one way to maximize potential profit is by scaling in.
The method of scaling is to open many positions at different levels that are pre-planned. In general, traders can enter a trade in the following circumstances:
- Entry at the current market price.
- Entry at a breakout state.
- Entry at a pullback state (retracement or reversal).
With the scaling in method, adding the next entry position can be done as follows:
- Entry at the current market price, scale in (added position) when a pullback or breakout occurs.
- Entry at breakout conditions, scale in at the time of pullback, or during the second breakout.
- Entry at pullback states, scale in at the time of the breakout, or during the second pullback.
An example of scaling in strategy at pullbacks
To find the right timing for entry on scaling in strategy, we can use support resistance or Fibonacci Retracements as references. We can also combine them with chart patterns or technical indicators.
5. Scaling Out
The scaling out method is a planned exit of several trading positions at different price levels. Scaling out relates to trading positions resulting from the scaling in strategy, where the stop level and target of each position can be different, or it can exit based on the trailing stops.
In scaling out the strategy that is based on reduced position sizing, we can take away the lot by half in a position that is still floating. This method can be done when the open position is still profitable, but the price starts to reverse direction.
Well, the main purpose of scaling out is to secure the profits you have earned so when the price turns against your previous trades, some of your profit will be safe even if it may not reach the initial target. This is very important and beneficial considering how unpredictable the forex market is.
While the potential profit in forex trading is enormous, there is also a substantial risk of loss hidden. Given the nature of high volatility in its prices, forex trading might be quite difficult to master, especially when someone is new to the business. Past performance is not indicative of future results. Even worse, most traders get confused and make forex trading seem even much harder than it has to be.
That's why it is highly advisable to invest some time and master some fundamental knowledge such as strategizing Position Sizing as money management tricks that can save you. These skills will increase your chance of survival and allow you some time to grasp the idea of managing the risks in forex trading. This way you can learn the basics and produce a good trading style that is most suitable to your risk appetite, capital, and finally, your targeted profit.
Now that you have learned several money management strategies in forex trading that you can apply, you can choose one or combine several of them that you think is most suitable to you. To make your planning easier, use the money management calculator that can adjust the results based on your trading rules.