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Tuesday, October 8, 2013

How much money (trading capital) do you need to trade?



Not everyone is going to have the same amount of money to start with. The amount of money you have – the size of your trading capital – will determine the position size that you are able to trade with.
The position size is essentially the amount of money you put into the market – in other words the amount that you trade. The larger the position size, the more money you will make if the trade wins. However, this also means you can lose more money. This is why using the correct position size is so important, because you can keep within the correct limits of money management and protect your capital from losing trades.
So how do you determine how much you should risk?
As you know, you should never risk more than 1-2% of your trading account on any single trade, which is why your trading capital will determine how much money you can trade with. However, the size of your stop loss will also determine the size of your position, because whatever your trading capital is, the larger the stop loss, the more you will have to reduce your position size to make sure that you keep within the correct limits of money management.


The different types of position sizes

When trading forex, there are three different types of position sizes that are usually available to you:
  • Standard lot
  • Mini lot
  • Micro lot
Each one requires a different amount to trade, depending on your stop loss. We will first explain the difference between them using an example of a trade with a fixed 20 pip stop loss.

Standard lot

 

 

In forex, a standard trading contract equates to 100,000 units of the base currency. This is known as a standard lot. This means that one standard lot has a value of roughly $10 per pip (depending on the currency pair you are trading), so if the market moves 1 pip in your favour, you make $10; if the trade moves against you, then you will lose $10 per pip. If you open a trade and the market moves against you by 10 pips, this equates to $100.
A standard lot equates to 100,000 units of currency. This means that a standard lot has a value of roughly$10 per pip.
In order for a trader to be able to trade a standard lot, you would need a large enough account to withstand a losing trade at $10 per pip.
If you open a trade that has a 20 pip stop loss; this means that a losing trade on a standard lot is $200.
In this case, you must have an account of at least $10,000 – 2% of $10,000 is $200.

Mini lot

 


Some people do not have a trading capital of $10,000 and so brokers are able to offer a different position size for traders with less capital to start with. They do this by subdividing the standard lot contract into ten; this is known as a mini lot.
A mini lot equates to 10,000 units of the base currency.This means that a mini lot has a value of roughly $1 per pip.
A mini lot is equal to 10,000 units of currency. This means that instead of each trade having a value of $10 per pip, each trade will now have a value of $1 per pipand you can start with less than $10,000.
If you open a trade with a 20 pip stop loss; this means that a losing trade is $20.
In this case, you could trade quite comfortably with an account of $2,000 – 2% of $2,000 is $40.

Micro lot

 

Some people, however, do not have or do not want to start with a trading capital of $2,000. Brokers have therefore introduced the micro lot that divides the mini lots further by ten.
A micro lot equates to 1,000 units of the base currency. This means that a micro lot has a value of roughly $0.10 per pip.
This means that each contract traded is 1,000 units of currency and gives each pip the value of $0.10.
A trade with a 20 pip stop loss will result in a $2 loss.
In this case, someone can start trading with as little as$500 or even $150  2% of $150 is $3.

Determine the maximum position size you want trade with depending on your account

Of course, not every trade is going to have a stop loss of 20 pips and so it is important for you to determine the position size for each trade.
In order to do so, you can apply the following formula that will tell you how much you can trade depending on the size of your trading account and the size of the stop loss:
Position Size in Lots = (Account Size X the % risk per trade) / (Stop Loss in Pips X Loss per Pip per Lot)
Lets say that you have a $5,000 trading account and you have a 15 pip stop loss. You only want to risk 2% of your account. Assuming that you are trading with US dollars, where each standard lot traded means that a pip movement is $10, the position size is calculated as follows:
Position size = ($5,000 x 2%)/ (15 x 10) = 0.66
You always round the result down. This means that you can trade 0.6 lots, or 6 mini lots for this trade.
So, in order to trade comfortably with 6 mini lots, you need an account size of $5,000 to stay within a 2% limit risk.
Be careful when using the formula to make sure that the currency of the numerator and denominator are the same – if not, convert one into the other at the current market price.

Summary

So far, you have learned that ...
  • ... the amount you can trade with depends on the amount of trading capital you have and the size of the stop loss on the trade.
  • ... the different position sizes in the forex market are a standard lot, where each pip moment is worth $10, a mini lot, where each pip movement is worth $1 and a micro lot, where each pip movement is worth $0.1.
  • ... in order to calculate the exact position size you can use the formula: 
    Position Size in Lots = (Account Size X the % risk per trade) / (Stop Loss in Pips X Loss per Pip per Lot).

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