Forex Position Sizing: How Much Should You Invest?

Why Position Sizing is Important

Position Sizing refers to determining the most suitable investment for a single trade. Deciding to invest 10 euros rather than 100 is already Position Sizing. It's an important topic, as exposure is correlated with risk but also with opportunities. Investing a lot means risking losing a lot, but it also guarantees the possibility of earning a lot. Position Sizing, therefore, is an activity that rests on a delicate balance between risk and opportunity, loss and gain, impoverishment and enrichment. It's evident that it cannot be left to chance or intuition. As all traders have experienced firsthand, making choices based on intuition is a terrible idea. Lucidity and the ability to reason with a cool head are two precious assets, but also aleatory, especially in moments of stress. And the practice of trading, including Forex, is a stressful moment. Perhaps it's one of the most challenging moments of acute stress ever. Also because money is always at stake. It's obvious, therefore, that one runs the risk of being overwhelmed by emotions, and emotions almost by definition reduce the space for lucidity, for speculative reasoning. Is there a solution to all this? Obviously yes. We're not talking about a magic wand, but rather a resource that is certainly useful, and that provides a compass during phases that, otherwise, would be governed by chaos or, even worse, by emotions. This solution is represented by rules. Those who establish rules for themselves set a track to follow. In this way, it's more difficult to "get lost," it's more difficult to make mistakes. This obviously also applies to Position Sizing. If exposure is determined according to a system of rules, everything is simpler. Above all, there is a lower risk of making mistakes.

A Simple Method

Better to put your hands up: there is no infallible method, not even when it comes to Position Sizing. Part of the trading activity is tied to the concept of chance, that is, to randomness. There is always the risk that a trade will go wrong, even when it is the result of a prudent approach and subject to rational rules. In the same way, an exposure can turn out to be reckless or, on the contrary, too "timid" even when the best Position Sizing methods are applied. It can easily happen that in hindsight an investment may turn out to be too skimpy, and knowing about a wasted opportunity. It happens just as frequently that an investment may turn out to be too bold, obviously after a loss. In any case, working with fallacious rules is always better than working without rules. Now, there are many rules, or rather methods for Position Sizing. In this paragraph we present the simplest one, while in the next one we present the one that, over the last few years, has gained the most success. The simplest method is so simple that it doesn't have a name. We can say that it responds to the natural instinct of any investor, beginner or expert. It is the result of a kind of optical illusion, of a cognitive bias that forces the mind to reason in proportions, and therefore always in relation to one thing with another. We could define it as the percentage method. Very simply, it is a matter of always investing the same percentage of capital. In this way, rash decisions are avoided, which among other things can always happen when trading: as we have already anticipated, the trader risks being overwhelmed by emotions, and among these there is the desire for revenge, which pushes to invest more and more to recover a loss. In any case, the percentage universally (and arbitrarily) recognized as balanced is 2%, although some tend to go down to around 1% and others aim for 3%. This simple rule, for example, suggests investing 200 euros if the capital is 10,000, 400 euros if the capital is 20,000 euros and so on. It is an obviously conservative method, also because it provides the possibility of losing fifty times in a row, before reaching zero.

The Kelly Method

The discourse is radically different for the Kelly method. Indeed... For the formula. Kelly was not a trader, but a physicist. In 1965 he devised a formula to manage the problem of background noise for telephone calls, but it was immediately realized that that formula was actually useful above all for managing risk, that is, exposure to it. A formula that is only apparently complicated, but which in truth can be used by any trader. The formula is as follows. K = W - ((1-W/R) Where K stands for the percentage of capital that it would be good to invest for each trade. This is a percentage normalized to 1, so the value 0.1 actually corresponds to 10%, the value 0.01 to 1% and so on. W stands for probability of winning. This value can be derived simply by relating the number of wins obtained by trading on that asset to the number of trades executed (always on the same asset). All, of course, normalized to 1. R, on the other hand, is the ratio between the average of the wins and the average of the losses, always for the same asset subject to Position Sizing. Let's try an example. Let's imagine a 40% probability of winning and a 1.6 average win to average loss ratio. The formula will be as follows: 0.4 - ((1 - 0.4)/1.60 An expression that when solved produces: 0.4 - (0.6/1.6) = 0.025 In this case, it would be good to invest 2.5% of the capital.

Tips for Good Position Sizing

What we have described so far is only a part of the gigantic topic of Position Sizing, which in turn is only one of the many topics of money management and risk management. Mastering these simple methods, however, already offers a certain advantage. Provided, however, that you take the matter seriously, and adopt an intelligent approach. To do this, follow these tips. Establish rules for Position Sizing long before trading. Choosing under stress is dangerous, and this also applies to Position Sizing rules. The advice, therefore, is to establish the rules in a state of serenity, away from pressure. Try several methods, but in complete safety. It is legitimate to try several Position Sizing methods, but to use them, utilize demo accounts or backtesting, that is, test the methods either in a real simulation (demo account) or on past market moments (backtesting). Never derogate from the rules you have set for yourself. Once you have made a choice, unless there is strong evidence to show you that it is wrong, continue along that path. Changing often is not a good idea, if it is not supported by compelling data.