For many new forex traders, the promise of quick riches is difficult to resist. That is the main reason why every day,

so many people from all walks of life begin trading the forex market.

While some element of this "keep your eyes on the prize" mentality is necessary to get traders through the tough times,

on any given trading day one should really focus on other things first.

When contemplating any kind of trade set up, a trader MUST understand that no matter how perfect the setup is,

it is possible for something to go wrong and the trade may end up being a loser. That’s ok – it happens to everyone.

Inherent in the forex market is a certain degree of randomness. That is not to say that the market is completely random – it isn’t –

but it is so complex that a certain degree of randomness must exist.

It is simply not possible to have all the information that all market participants are reacting to,

or to predict how any of them will react to said information. Moreover,

this randomness is necessary for the proper functioning of any financial market:

If everyone knew the direction of the market, then there would be no market - a market depends on there always being a buyer and a seller.

The randomness cannot be eliminated, but it can be managed.

So back to our perfect setup that failed: how could this have happened? Well,

as luck would have it, as a part of its quarterly internal accounting procedure,

some random multinational corporation just happened to be buying the currency that you sold, driving up its value – that is,

moving the price against your position, and triggering your stop loss order. If you were smart, and you managed this randomness,

or risk, in a logical manner, you can take the loss in stride and live to trade another day.

This is just a part of what every trader may have to go through on any given dog-day afternoon.

So how do you manage this "risk"? There are volumes of books written on the subject, and there are many different methods to accomplish this,

but really what we are talking about is "how much are you willing to lose on this trade if it goes against you?"

The answer should come from your money management rules, which are a slightly different topic (we will discuss this in an upcoming article).

Suffice it to say that most traders live by the rule that no more than 1-2% of your account should be risked on any one position.

What we are dealing with here then, is how do you make sure that you only risk x% of your account?

What many novice traders believe is that you should use x% of your margin on every trade,

but that is EXTREMELY DANGEROUS and not in line with proper risk management. The reason is simple:

such a calculation does not even take into account your trade setup.

If you are placing a long-term trade with a 1,000 pip stop loss,

you could very well be facing a margin call long before price reaches your stop loss level.

On the other hand, if you are placing an intraday trade with a 15 pip take profit, then your profit will be insignificant.

There must be a way to take into account your exact trade setup and to choose your position size accordingly.

The trade setup must determine position size, NOT the other way around! This is one of the most critical aspects of retail forex trading,

and many traders simply don’t get it (or don’t care). Let’s illustrate this with an example:

Say you have a $10,000 mini account with an MT4 broker that allows you to trade 0.01 lots (minimum trade size would be 0.01 x 10,000 = 100 units).

Your margin requirement is 1% (that is the same as saying your maximum leverage is 100:1).

Now say the current price of EUR/USD is 1.2600 and you see a nice setup:

you want to go long at 1.2500 because it is a strong support level and your analysis tells you there is a strong likelihood of a move upward from there,

should price go as low as 1.2500. Your analysis also tells you that if price drops below 1.2050,

the trend is not in your favor and you should exit the trade with a stop loss order.

Strong resistance is found at 1.3500 and all signs point to price reaching that level in the coming weeks,

so you take this to be your exit target so you set your take profit at that level.

You go on to place your buy limit order at 1.2500, but before you do, you need to figure out the optimal position size.

How much do you want to buy at 1.2500?

The wrong way:

Then you remember someone, somewhere telling you that using 1% of your available margin is the same as risking 1%.

You do a quick calculation and you see that your position should be 1 mini lot, or 10,000 units of EUR/USD. Happy with yourself,

you enter your buy limit order at 1.2500, with a stop loss at 1.2000 (just below your threshold of 1.2050, so your trade has some extra room to breathe).

Unfortunately for you, there is a dramatic rise in the interest investors demand to hold Spanish bonds, dealing an unexpected blow to the EUR.

Your support level does not hold up. EUR/USD dips below your stop loss level and you just lost your trade.

No big deal, you were risking just 1% of your account. EUR/USD pip value on a 10,000 unit trade is $1 and you lost 500 pips,

meaning you lost $500 and your balance is now $9,500. But wait, $500 is NOT 1% of your account.

It is 5%! The definition of "amount at risk" is the maximum amount you can lose if the trade goes against you… So if you risked just 1% of your account,

how is it that you lost 5%? Obviously there is something very wrong with your calculations. Aren’t you glad you were trading demo?

Otherwise it would have been a very expensive lesson.

The right way:

You have now understood that the "amount at risk" is not the same as "used margin". In fact, they are two very different things.

The amount at risk is the amount you stand to lose if price hits your stop loss order. Luckily for you, it is very easy to calculate. Here is how:

position sizing formula

Where:

X is the position size (in units of the base currency), and the value we are trying to calculate

R is the % of account you wish to risk

B is the account balance

T is the long/short indicator: -1 if short position, +1 if long position

P1 is the entry price

P2 is the stop loss (exit) price

Simply substitute in the values and we get:

position sizing formula with example numbers substituted in

And we get a value of:

X = 2,000 units

So the ideal position size for the desired setup would be 2,000 units of EUR/USD.

We can run a quick check because we know that all currency pairs with USD as the counter currency have constant pip values of $1 per 10,000 units.

So a position of 2,000 units would have a pip value of $0.20. Multiply this by 500 pips, and we get an "amount at risk" value of $100,

which is 1% of our $10,000 account, so everything checks out. Please note that the above formula works for all USD/XYZ and XYZ/USD pairs,

but does NOT work for crosses (ABC/XYZ) because the pip values for crosses depend on the underlying USD/XYZ pair’s price.

We can also use a variation of the above formula to calculate the "reward", or the amount you stand to gain if the trade does pan out the way you planned:

reward amount calculation

(NOTE: the positions of P1 and P2 have been reversed as compared to the risk formula)

Where:

W is the Win, or "Reward" amount and the quantity we are trying to calculate

X is the position size we calculated

T is the long/short indicator: -1 if short position, +1 if long position

P1 is the entry price

P2 is the stop loss (exit) price

Knowing the risk amount as well as the reward amount, we can determine a Risk-to-Reward ratio and over a large number of trades,

we can also determine the mathematical expectancy of our trading system or strategy. This is one of the most useful,

though often statistically unreliable pieces of information we can gather.

We will learn more about this concept in our follow up article "Mathematical Expectancy in Forex".

The above examples also pre-suppose a highly liquid market at all times,

meaning that your orders will all get filled at the exact price you want. In reality, this is not always the case.

Your orders may or may not get slipped by a few pips, creating an extra loss which may or may not be significant,

depending on how big of a chunk of your account those "few pips" are.

If you are an intraday trader that trades relatively large positions over short timeframes, then a "few pips" can add up to be quite a bit.

On the other hand, If you are a swing or position trader who uses small positions to gain hundreds or even thousands of pips per trade,

then a few pips here and there will not make a big difference in the long run.

How much of a difference this makes is directly related to the average "amount at risk" of your trading system or strategy.

The higher the "amount at risk", the more pain slippage can cause you.

It should also be mentioned that there are many other ways to manage risk in the forex market,

including the use of forex options and other instruments as a hedge against unexpected price movements.

These function in a slightly different and more complex way, and are beyond the scope of this article.