Position Sizing Rules

Following a small discussion I had about advantages and disadvantages of using different position sizing techniques in the ATC 2011 championship of the expert advisors I decided to talk a bit more about various position sizing rules that can used in Forex trading. It’s a very important topic and this blog’s readers agree with this thesis. In my opinion, there are 5 main types of position sizing techniques:

  • Fixed position size
  • Martingale position sizing
  • Fixed fractional position sizing
  • ATR-based position sizing
  • Risk-based position sizing
  • Below I try to explain more about each of these systems of rules.

    Fixed position size
    Probably the most widely used position size — a trader just uses a fixed lot size (for example, 1 standard lot) on all the positions. The technique is very simple to implement — both manually and in expert advisor. It doesn’t require any calculations. The problem is that it’s very limited and can be quite dangerous (if the fixed size is too high).
    The income of the trader 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 fixed position size to some large amount compared to the account balance, there’s a danger that the account will get wiped out in case of a continuous losing streak.
    For my ATC 2011 EA I’ve chosen this type of position sizing because it offers a very fast buildup of balance in the beginning and becomes less aggressive in the end. So far I’ve been lucky with it: after one big loss, 2 positions are showing nice profit. Nevertheless, I don’t recommend this position sizing system for your real account trading.
    Example: Every position’s volume is set to 3 standard lots.

    Martingale position sizing
    If you think that the 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’s derived from Martingale gambling system, which involves doubling your bet anytime you lose and was very popular back in XIX century; it is still popular among some gamblers and Forex traders. This system offers a sure-fire money winning method for a trader with the 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 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’ve 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.

    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 trade. The idea is to minimize the risk of ruin and to increase exponentially the income in case of a continuous profitability of the employed trading strategy.
    Although, it’s probably the most effective and safe position sizing systems for Forex, unfortunately, it also has its disadvantages. The biggest of them 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. I’ve dropped this method specifically because of that disadvantage, as my ATC 2011 EA often shows significant losses after winning a trade. Second disadvantage is a rather slow buildup of the account balance compared to fixed position sizing if moderate fraction ratio is used.
    Example: Your account balance is $7,500. You decide to set your position size to 0.01% of your account size. $7,500 * 0.01% = 0.75 lot. So you set your position volume to 0.75. If you win, let’s say, $500, your balance increases to $8,000, and 0.01% of it will be 0.8 lot. If you lose, let’s say, also $500, your balance becomes $7,000, and 0.01% of it will be 0.7 lot.
    As you see, it is a very flexible position sizing system because you can vary the ratio and thus the risk according your preference.

    ATR-based position sizing
    Actually, it is just an additional rule for the fixed fractional position sizing technique (but can be used with any of them). It involves position size normalization according to the current value of Average True Range (ATR) indicator. ATR shows the volatility of the market. As 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 presumably less probability of a price spike to hit the stop-loss.
    This position sizing add-on is useful for the trending Forex strategies and can be harmful for range trading where spikes can be useful to hit take-profit.
    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 amount of required calculations is better used with the automated Forex expert advisors rather than manually.

    Risk-based position sizing
    This one is also an addition to the other position sizing rules and is more popular with the fractional position sizing too. While, usually, a Forex trader bases the position size solely on the size of the account, here, one would also apply 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 calculate position size for risk-based method easily, you can use our free online Forex position size calculator.
    Some traders also use no position sizing rules in Forex at all. That’s not a very professional trait. Position sizing can help you to improve the strong points of the trading strategy and decrease the chance of ruining the live trading account. If you know traders that still size their positions chaotically, direct them to this article, please :-).

    If you have some questions or comments regarding the listed position sizing rules in Forex, please feel free to reply using the form below.

    Leave a Reply

    Your email address will not be published. Required fields are marked *