How to Optimize Position Size in Forex Trading

How much money is it good to invest in a single trade? It's a question that all traders should ask themselves, also because it has to do with a discipline that is then a real lifesaver for those who try their hand at online trading: money management? Here is a comprehensive guide on how to decide the size of the position in Forex Trading.

Position Trading with Kelly

Let's clarify one point right away: in reality, there is no single method to determine the position size. Money management itself is a flexible discipline, which by its nature adapts (or should adapt) to each person's trading style and, in particular, to their risk propensity. It's obvious: if the risk propensity is high, for a whole series of reasons, even for a greater economic availability, then the position size will be more substantial. A method that more or less satisfies everyone, but which is still loose for some and tight for others, is the one featuring the Kelly Criterion. Who is Kelly? And what does his method say? Actually, John Kelly wasn't born as a trader, far from it. In fact, he worked for AT&T's Bell Laboratory, so he was basically a technician. However, when he developed a method to study the noise problems that disturbed telephone lines, some players realized that, miraculously, just by chance, this method could be applied to the world of betting. Specifically, to optimize betting stakes, in short, to do the so-called "bet sizing". From here to the size of the position in Forex trading, the step is short. After all, what is the determination of trade size (in English, position sizing) if not an optimization of betting stakes?

The Kelly Criterion

The Kelly Criterion, actually, is more difficult to explain than to use. First, you need to know the two fundamental components that constitute it, which are: The winning probability, i.e., the probability that each position will result in a win (gain). The ratio between average win and average loss (winAV/lossAV ratio), i.e., the average value of positions that ended in a win divided by the average value of positions that ended in a loss. Now, we can state the formula, which at first, and without knowing the other terms, can be incomprehensible. Kelly % = W – (1 – W) / R Let's shed light on the terms. W is the winning probability R is the winAV / lossAV ratio The formula returns a percentage rather than an absolute number. It couldn't be otherwise, since all traders start from different capitals. What is this percentage calculated on? We will answer this question later. First of all, it is necessary to calculate W and R, and it's not a walk in the park. Both to calculate W and to calculate R, you have to carry out a study on your work as a trader. Exactly, we are in the field of statistics or, at least, data collection. This is the greatest strength of the Kelly Criterion, which makes it suitable for each trader. In fact, it is tailored to one's personal history. However, this implies a lot of work: recording the last 50 trades. You can do it manually (in a relative sense), i.e., by studying the list of your broker, or use a much more convenient mechanical trading system, which provides back testing. From here, calculating W is relatively simple: take the number of positions in gain, i.e., those that ended with a win, and divide it by 50. If, for example, you won 30 times out of 50, the W will be 0.6. Now, calculate R, which is already more difficult. You must first add up the values of the wins and divide by the number of wins themselves. Let's assume that the sum comes out to 15,000 (euros, obviously). The partial figure will be 500 euros (the wins were 30, remember?). Subsequently, you have to do the same for the losses. Let's imagine that this second sum returns 6,000, which divided by 20 makes 300. Now, derive R simply by putting the two averages as a fraction. 500/300 makes 1.66. All that remains is to insert the values thus obtained into Kelly's formula. How are the results interpreted? A clarification: the result always gives a number less than one. To be precise, between zero and one. Multiply by 100 and get the percentage of the portfolio to spend for a single trade. In the example we made, the formula returns 0.36. This value, rendered as a percentage, gives 36%. Does this mean that you have to invest 36% of your portfolio for each single operation? Certainly not. It simply indicates the maximum you can invest. The size of the position in Forex Trading, even according to the Kelly criterion, is subject to a ceiling, which is then the ceiling of common sense. This says that it is always inadvisable to invest more than 20% of your portfolio. It goes without saying that the Kelly Criterion works especially well on those traders who don't string together the classic winning streak, and that's fine since Position Sizing is a problem for everyone, but especially for those who have profitability issues. Also because if we only try to slightly lower both the probability of winning and the average gain, the final percentage is much lower. If we try to use the numbers that losing traders produce, it is really close to 1%. However, it can be argued how effective the Kelly Criterion is, since nothing is perfect in this world and everything is, on the contrary, refutable. Well, it depends on the use made of it. If it is the only money management tool, then it is destined to fail. Also because it does not act on a qualitative level, but only on a quantitative one. It does not say which trade is safe and which trade is less safe, it does not reflect market conditions. It simply gives a rough indication of the maximum supportable size, seen in light of the personal history of those who use it. It draws a boundary that, one can believe, is already a lot.