It has been said that the single most important factor in building equity in your trading account is the size of the position you take in your trades. In fact, position sizing will account for the quickest and most magnified returns that a trade can generate. Here we take a controversial look at risk and position sizing in the forex market and give you some tips on how to use it to your advantage.
The Undiversified Portfolio
In the book The Zurich Axioms, author Max Gunther states that in order to break away from the "great un-rich," an investor must avoid the temptation of diversification. This is controversial advice, since most financial advice encourages investors to diversify their portfolios to ensure protection against calamity. Unfortunately, nobody gets rich from diversification. At best, diversification tends to balance winners with losers, thus providing a mediocre gain.
The author goes on to say that investors should "keep all [their] eggs in just one or two baskets" and then "look after those baskets very well". In other words, if you are to make real headway with your trading, you will need to "play for meaningful stakes" in those areas where you have sufficient information to make an investment decision.
To measure the relevance of this concept, one need only to look at two of the most successful investors in the world, Warren Buffett and George Soros. Both of these investors do play for meaningful stakes. In 1992, George Soros bet billions of dollars that the British pound would be devalued and thus sold pounds in significant amounts. This bet earned him more than $1 billion virtually overnight. Another example is Warren Buffett's purchase of Burlington Railroad in a $44 billion deal—a significant stake to say the least. In fact, Warren Buffett has been known to scoff at the notion of diversification, saying that it "makes very little sense for anyone that knows what they are doing."
High Stakes in Forex
The forex market, in particular, is a venue where large bets can be placed thanks to the ability to leverage positions and a 24-hour trading system that provides constant liquidity. In fact, leverage is one of the ways to "play for meaningful stakes". With just a relatively small initial investment, you can control a rather large position in the forex markets; 100:1 leverage being quite common. Plus, the market's liquidity in the major currencies ensures that a position can be entered into or liquidated at cyber speed. This speed of execution makes it essential that investors also know when to exit a trade. In other words, be sure to measure the potential risk of any trade and set stops that will take you out of the trade quickly and still leave you in a comfortable position to take the next trade. While entering large leveraged positions does provide the possibility of generating large profits in short order, it also means exposure to more risk.
How Much Risk Is Enough?
So just how should a trader go about playing for meaningful stakes? First of all, all traders must assess their own appetites for risk. Traders should only play the markets with "risk money," meaning that if they did lose it all, they would not be destitute. Second, each trader must define—in money terms—just how much they are prepared to lose on any single trade. So for example, if a trader has $10,000 available for trading, they must decide what percentage of that $10,000 they are willing to risk on any one trade. Usually, this percentage is about 2%-3%. Depending on your resources, and your appetite for risk, you could increase that percentage to 5% or even 10%, but I would not recommend more than that.
So playing for meaningful stakes then takes on the meaning of managed speculation rather than wild gambling. If the risk to reward ratio of your potential trade is low enough, you can increase your stake. This of course leads to the question, "How much is my risk to reward on any particular trade?" Answering this question properly requires an understanding of your methodology or your system's "expectancy". Basically, expectancy is the measure of your system's reliability and, therefore, the level of confidence that you will have in placing your trades.
To paraphrase George Soros, "It's not whether you are right or wrong that matters, but how much you make when you are right and how much you lose when you are wrong."
To determine how much you should put at stake in your trade, and to get the maximum bang for your buck, you should always calculate the number of pips you will lose if the market goes against you if your stop is hit. Using stops in forex markets is typically more critical than for equity investing because the small changes in currency relations can quickly result in massive losses.
Let's say that you have determined your entry point for a trade and you have also calculated where you will place your stop. Suppose this stop is 20 pips away from your entry point. Let's also assume you have $10,000 available in your trading account. If the value of a pip is $10, assuming you are trading a standard lot, then 20 pips is equal to $200. This is equal to a 2% risk of your funds. If you are prepared to lose up to 4% in any one trade, then you could double your position and trade two standard lots. A loss in this trade would of course be $400, which is 4% of your available funds.
The Bottom Line
You should always bet enough in any trade to take advantage of the largest position size that your own personal risk profile allows while ensuring that you can still capitalize and make a profit on favorable events. It means taking on a risk that you can withstand, but going for the maximum each time that your particular trading philosophy, risk profile and resources will accommodate such a move.
An experienced trader should stalk the high probability trades, be patient and disciplined while waiting for them to set up and then bet the maximum amount available within the constraints of his or her own personal risk profile.