Position Sizing For Forex Traders and CFD Traders

Unlike trading index future contracts or commodity future contracts having a steep margin requirement and higher minimum account size across the board, forex trading (and CFD trading) can be done with very small size account. I am not talking about the ability to go for 200 times leverage. I am talking about the flexibility the forex firms are offering that allows the traders to trade with very small lot size to scale the risk properly.

This combination of flexible lot size and high leverage arrangement make it possible to trade forex and CFD with very small initial risk capital and still achieving good performance with proper risk management. The important thing is that the trader has to keep a clear mind and has a conservative trading plan in place. Of course having a good trading strategy will help but it is not the most important factor in trading forex and CFDs successfully.

Let’s see how one can play this game smartly by controlling the position size.

$500 Play

Many traders go into forex trading because of the low margin and next to nothing account size requirement. There is absolutely nothing wrong with that because they are essential features which make forex trading a very good vehicle to make money. The real problem is that most traders do not realize their inexperience in trading require their full attention to protect their capital.

With just $500 put into an account for a test drive of trading forex and CFDs, it is very likely the account will be wiped out quickly not because of consistent bleeding from losing trades, but one to two very bad trades where the trader refused to cut loss. I have seen enough people doing that not just with very small size accounts but also with $5,000 or even $50,000 accounts.

Those who have very small size accounts often blame the wipe out on the fact that if they had put in an extra $500 into the account they would not have been cleaned by the house. I have to admit that it may be true, but for a rare few cases only.  Majority of those who think this way actually would lose the $1,000 instead of just $500 because they played the game wrong. They would face the exact same scenario again and again until they can see the situation in proper perspective.

i.e. blame themselves as oppose to blaming others or bad luck

Stop Loss Size Based On Emotional Tolerance

To avoid triggering the worst trading behaviour, one has to use stop loss the properly way. Proper means making sure the amount being stopped out would not make you so frustrated that you would forget about your trading plan. The stop loss has to be an amount acceptable to you psychologically. That is something I cannot help you with and you have to ask yourself honestly to figure out that.

As a rule of thumb, I find dividing the casual answers a rookie trader provided by 10 as the stop loss starting point is a pretty good one. It is not arbitrary. It is my experience that people usually overstate their emotional risk tolerance.

It does not matter if you start with a $10,000 account or $50,000 account. If you would lose your cool when you are hit by $100 stop loss twice in a row, you have to reduce the stop loss absolute size. The good thing with forex and CFDs is that you can do that by adjusting the position size easily. At smaller position size, you get to keep the stop loss strategy that you know works well instead of finding a stop loss method to meet your more restrictive need.

With something like emini S&P, with limited capital where you can only trade 1 or 2 lots, you do not have the flexibility in position sizing. Hence you must be compatible or you better trade something else. That brings up the issue of index CFDs which are offered by many forex firms. If you like to trade index, the CFD alternatives could be a good solution to the position sizing problem with regular index future contracts.

Overleverage Is Just A Word

At 200 times leverage, $500 can be used to trade up to (or close to) $100,000 position size. I know that most forex brokerages will not let you do that, but that is just minute details. The more important thing that you should pay attention to is the burn rate. Using maximum leverage, each pip will cost you $10 USD on the euro dollar pair. Just one single 50 pips move will wipe your account out with no change.

Using this extreme case, it tells us how easy it is to get an account wiped out if you do not have an exact plan in place to restrict yourself from trading beyond certain sizes.

Affordable Stop Loss Based On Dollar Value Per Pip

So how do you position yourself for sustainability? Apply simple statistics concepts to find out the acceptable survive level will do the job.

Using the magically textbook statistics constant of 30 samples, you can find out the conservative position size quickly. Based on the scenario of losing money 30 times in a row with fixed losses, and the account can still continue to trade, you can work out the answer following the example below.

Let’s say you expect that you need 50 pips stop initially for any open position using your strategy and that you are willing to lose up to $15 per trade (that already adds up to $450, leaving only $50 for margin). So you can afford up to $15 / 50 = $0.30 a pip in reality. It also implies your position size should not exceed $3,000 face value using euro dollar as example. $3,000 is 3 micro lots with many forex brokerages who offer special micro accounts.

Since $3,000 would require only $15 margin at 200 times leverage, that gives you some extra room on the reserved $50 but not quite enough to go for $4,000 position size.

Notice that at $3,000 position size, you are not using 200 times leverage at all. In reality, it is just 6 times your capital. Trust me, it is still very aggressive use of capital, yet improves your chance of survival significantly over using 10 or 20 times leverage.

Always Choose The Smaller Stop Loss Amount

When you have a bigger account to work with, the maximum stop loss amount you can throw behind each trade will increase. For example, if you trade steadily and worked your way from $500 to $5000, you will be able to afford $150 stop loss per trade following the logic outlined in the previous section. That is the maximum your account allows you to but you should not simply increase your stop loss size and position size just because you can. Instead, pay attention to your emotional tolerance level and cap your stop loss amount to one that you feel comfortable with.

It is the other advantage of forex and CFD trading. You can increase your trading size in fractional manner so that you can get comfortable with the risk you are taking and increase your position size gradually right from the start when you have very limited capital. That makes it much easier for small traders to grow into decent size traders. In another words, forex and CFDs provide better opportunities to those who are interested in building a solid trading career comparing to other instruments.

Trading Capital Can Be Different From The Trading Account Size

One practice many pro traders do is to keep liquid asset around for trading. As long as you are discipline enough not using these money for other purpose, these funds can be used in the calculation of conservative position size. What that means is that you know clearly how much capital you are committing behind your trading with a specific brokerage and that you know exactly the leverage you are using. To the brokerage your account could look very aggressive but you know better in this case.

There are many reasons why we choose not to keep large amount of money at a brokerage. One of them is the safety of the fund. After so many problems happened with the brokerages over the past few years. Many of us are much more careful with money put into brokerage accounts. Parking just enough money for trading at the firms and keeping the rest of the liquid capital at bank accounts with deposit guarantee or insurance by US or Canadian authorities gives us a peace of mind. Remember that different countries and regions do have different rules for this type of insurance so be sure to read the fine prints to know what your rights are. And do not park much more than the maximum insurable amount with any single institution if you are extra cautious.

Summary

As a summary, the leverage the brokerage gives you is not your excuse to bet your account irresponsibly. You do have control of your position size. And that is really what matters most. By keeping your position size reasonable relative to the trading capital you have, it will buy you more time to learn to trade before exhausting the trading capital. Once you become consistently profitable, it will also serve you well as your foundation to grow your trading business steadily.

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