Position sizing involves making an objective decision about what positions to take when trading, and it makes up an important part of just about any sound money management strategy. As a result, it would be a good idea for forex traders to incorporate some form or position sizing methodology into their trade plans.
Furthermore, many successful traders routinely assess the risk reward ratio of a particular trade they are considering entering as part of their decision making process. Some of them even incorporate criteria based on risk reward ratios into their trading plan.
An additional application of risk reward ratios among forex traders is in performing position sizing. Such a technique usually increases the size of a position depending upon how successful the trade is anticipated to be.
Determining the Risk-Reward Ratio on a Trade
The basic idea involves quantifying the anticipated amount of risk or loss that the trade might result in and then comparing this to the trade's quantified potential returns. To perform a risk-reward ratio calculation in its most simple sense for a particular forex trade, you would just calculate the number of pips from your entry rate until your stop-loss level and compare the result to the number of pips until your projected take profit level.
In general, a risk-reward ratio of 1:2 means that you would risk one pip of loss to potentially earn 2 pips.
To provide a general guide, most successful traders will not enter a trade unless the risk they foresee for it is less than half of what their anticipated reward will be. This means they have a 1:2 minimum Risk/Reward Ratio criterion for any trades they will consider entering.
Basically, having your risk be less than your potential reward on prospective trades is one of the recipes for successful money management over the long term when trading forex.
Of course, once a trade is entered, any changes to the stop loss or take profit levels, perhaps using the technique of trailing stops will change the risk reward ratio of the position.
Using the Risk Reward Ratio
Traders often use risk reward ratio criteria to help them place stop loss orders and also when assessing how large a position to take. In addition to assessing the risk reward ratio the trader is willing to assume before any trade, they may also take into account important technical analysis factors like the presence of nearby support and resistance levels.
Most successful traders refuse to take on a position unless they can expect to at least make twice the original investment. This would be a minimum risk/reward ratio of 1:2, where they risk one unit to make two.
They can also take on larger trades when a higher probability of success is anticipated, perhaps using the risk reward ratio as a criterion for doing so.
Sizing Positions Based on the Risk/Reward Ratio Alone
Although simpler ways exist to size positions, using a risk reward based position sizing method means that a trader will take larger positions when the trading opportunity seems more likely to be profitable. As long as the risk taken on each still falls with acceptable risk taking parameters, then this can be a successful enhancement to a trading plan.
Perhaps the easiest way to size positions based on the risk reward ratio would be to first compute the ratio, and then take positions only if it is better than say 1:2, for example. Then, a trader could take a position in direct proportion to how profitable the trade might be.
For example, a trader observing a 1:2 risk reward ratio for a potential trade could take a two lot position. Similarly, they might take a three lot position if the ratio was 1:3, or a four lot position for a ratio of 1:4, and so on.
The Risk-Reward Ratio for Your Overall Forex Trading Business
In order to gain a suitable assessment of the business risks that you may face when trading forex, you can perform a more advanced form of risk/reward analysis.
The steps to go through when performing such an analysis might go as follows:
Step #1 - Research Possible Risks -
You will first need to do enough research into your new forex trading business so that you can effectively foresee any potential risks that may arise.
Step #2 - Estimate Potential Losses and Rewards
Now reasonably determine the potential financial loss that you might incur as a result of the risks you foresee as possible coming to pass. Also compute the potential financial rewards that you hope to earn from forex trading.
Step #3 - Probability-Weight Potential Losses and Rewards
An optional step would be to weight each risk and reward by your best estimate of the probability of it actually occurring in your particular situation to get a set of probably-weighted potential losses. You can then sum these weighted losses up to get a total loss number and can do the same with the weighted rewards.
Step #4 - Compare Risks to Rewards
Now look at the sum of the weighted or un-weighted potential losses and compare it to the sum of the weighted or un-weighted potential rewards. This will give you a risk/reward ratio that you can use to see if your forex trading business makes sense.
Basically, after performing a probability-weighted risk/reward assessment for your forex trading business, you should see a substantially higher chance of success, preferably by a factor of at least two, than your chances of loss.
If not, then be sure to ask yourself why would you want to enter such a risky business in the first place since your time might be better spent elsewhere.
The probability-weighted risk/reward assessment would also help you to take larger positions when you are more certain about the outcome for a particular trade. In essence, using this technique would allow you to take bigger positions when a trading opportunity presents itself with a high probability of profit and a high potential return.
Alternatively, smaller positions would be taken for lower probability trades with lower returns.
The Importance of Managing Risk
Without a clear concept of risk, a trader can easily take on more risk than they can handle which eventually leads to cleaning the trader out of their money and the trader going back to their day job.
A successful forex trader typically knows not only the risk reward on any given position, but what percentage of the account is at risk on any given trade. An accepted size for an individual position in a forex account puts no more than 2% at risk on any given forex position.
The amount of risk that a trader assumes on any given position can be immediately assessed with the size of the positions in relation to the size of the account.
Building an account gradually and increasing the trading units as the size of the account increases makes the most sense. Nevertheless, many novices begin trading without assessing their risk and without sizing their positions according to sound money management principles.
Remember that trading in the forex market has a very high risk factor, regardless of what you may have heard. Trading in the forex market is a serious business if you value your money, so it makes sense to treat it that way by having a sound trading plan that incorporates good risk management practices.