Hello traders! One of the main topics of conversation that I have with new traders or students at Online Trading Academy is about the quest for trading’s Holy Grail. While most are interested in a combination of technical analysis studies with supply/demand and a trend indicator or three, the actual Holy Grail is none of the above. In fact, it is much easier! The actual Holy Grail is proper risk management. That’s it. End of newsletter, talk to you in two weeks!
Actually, it is a bit more complicated than that. As we’ve mentioned numerous times, the two main traits that successful traders have in common is to cut their losing trades early, and letting their winners run – usually with a reward to risk ratio of 3:1. In this week’s Lessons from the Pros newsletter, I’d like to go a bit more in depth into your position sizing as you are learning to trade. Learning to trade is much like learning anything new in life – riding a bike, playing golf, or playing a video game. The main difference is the fact that you can lose money while you learn – sometimes a lot of money! In fact, some people lose or “blow up” their entire trading account as they are learning this great thing we call trading. I always recommend new traders to start trading very small position sizes while they are learning, and here is a scale, or “ladder,” that we use in class:
- Position size: demo, to get a baseline
- How long? 20 trades, or 2 weeks, whichever is longer
During this period, I want you to keep track of a few performance measures – your win/loss ratio, average winning trades and average losing trades. For example, after 20 trades, you may have 10 winners and 10 losses with an average winning trade of 25 pips, and an average losing trade of 10 pips. This would be a profitable “baseline” of your performance. After you have a profitable baseline in the demo account, it’s time to jump into the real live money trading! So, how big of a position size should you take? A common amount of risk we recommend is 1-2% of your aggressive portfolio value. This means that if you have a $10,000 Forex trading account, we don’t want to risk more than $100-200 per trade. What I would prefer new traders do is start with an EXTREMELY small position size – 1 mini lot, if possible. (With smaller accounts, you may want to consider micro lots.)
With one mini lot of the EUR/USD, one percent of the above mentioned account would mean a stop loss of 100 pips – each pip is a dollar in this currency pair. If the trade you are considering only needs a stop loss of 20 pips, you could trade 5 mini lots, according to the 1% rule. However, you haven’t earned your trading stripes yet! Stick with the one mini lot because live money trading affects us differently than demo trading does. So, how long should you trade 1 mini lots? Just like you did in the demo platform – 20 trades, or 2 weeks, whichever is longer. Keep track of your performance – is it profitable? Was it close to your baseline from the demo account? If so, congratulations, you are doing it right! Now you may trade 2 mini lots. Guess how long? Two weeks, or 20 trades, whichever is longer. You can probably guess what happens next – 3 mini lots, then 5, 7, 10, 15, 20, 25, 30, etc.
Depending on your trade management style – all in/all out, scaling in and out – you may want to consider going from 10 mini lots to 1 standard lot. Some brokerage firms offer better pricing for standard lots vs. mini lot accounts.
There are two main reasons for this position sizing plan. The first is to have very small risk and losses until you get good at trading. What is the point of being a good trader if you’ve blown up your trading capital while you were learning?? Do you like working for someone else, scraping together a few dollars here and there to fund another trading account? The whole point is to have trading capital to trade and to change your life, not to watch the demo account video game!
The second reason I recommend this position sizing “ladder” is your emotions. The market doesn’t care about your position size – only you do. If you are down 20 pips on the EURUSD with two mini lots, it’s only $40. You probably have that much money in your change bucket at home! If you are down 20 pips on 5 standard lots, you are now talking about $1,000. And yes, you could be down that 20 pips in a few seconds! That $1,000 staring at you in the face might be difficult for you to handle in the beginning – the market doesn’t care about it, but YOU DO! So, the plan is to build up some emotional tolerance to the potential negative figures in your profit and loss column. Over time, that 20 pips is all you will look at – not the money. It won’t matter to you if a trade goes against you $40 or $1,000 – you are trading the chart, not the red and green profit and loss figures on the screen. Keep doing what you are good at and eliminate the bad habits – with proper position sizing, you will be able to keep the risk low until trading becomes simple!
Until next time,
Rick Wright firstname.lastname@example.org