Understanding Lot Size and Risk in Forex

I thought I would outline how lot sizing works in Forex as you need to consider this when assessing your trade risk when using the robot if you are turning off money management. FAPTurbo money management does a good job of determining lot size based on your account balance and available margin, but many people are turning this off and manually setting lot sizes.

Lot sizes are shown as a percentage of a full lot. 1 full lot in forex is equal to $100,000.00 of the underlying currency so 1.0 lot of USDCAD equals $100,000.00 USD. If the USD appreciates versus the CAD you will have more than $100,000.00 (profit) if you went long (bought the USDCAD contract) and less than $100,000.00 (loss) if you went short (sold the USDCAD contract).
If the USD depreciates versus the CAD you will have less than $100,000.00 (loss) if you went long (bought the USDCAD contract) and more
than $100,000.00 (profit) if you went short (sold the USDCAD contract).

The amount of the profit or loss from a contract purchase are related to the lot size and the number of pips the underlying moved. Here is
how it works:

1.0 lot = $10.00 per pip, you are trading a full lot, or $100,000.00 of the underlying currency
0.9 lot = $9.00 per pip, you are trading a .9 lot, or $90,000.00 of the underlying currency
0.8 lot = $8.00 per pip, you are trading a .8 lot, or $80,000.00 of the underlying currency
etc….
0.1 lot = $1.00 per pip, you are trading a .1 lot, or $10,000.00 of the underlying currency
0.09 lot = 0.90 cents per pip, you are trading a .09 lot, or $9,000.00 of the underlying currency
0.08 lot = 0.80 cents per pip, you are trading a .09 lot, or $8,000.00 of the underlying currency
etc….
0.01 lot = 0.10 cents per pip, you are trading a .01 lot, or $1,000.00 of the underlying currency

**note: some currencies are not exactly $10.00 per pip or a fraction thereof but for our needs assuming so is fine.

Remember, recommended risk levels are no more than 1-2% of your account balance per trade.

So if you trade 0.1 lots, you are risking $1.00 per pip. If the underlying moves against you, and your stop loss is at 60 pips, you are risking $60.00. If your account is $500.00 you are risking 60/500 = 12% of your account on this one trade.

So with a $500.00 account what lot size should I be trading to only risk 1-2% of my account?
$500.00 X .01 = $5.00 risk per trade at 1%, $10.00 risk per trade at 2%

Now lets say our stop loss is 50 pips, so with $5.00 at risk (we have determined our comfort level is risking 1% of our account per trade), we need to be trading a lot size that only risks 0.10 cents per pip ($5.00/50=0.10) so to manage our risk we should set our lot size to 0.01 lots per trade. If your comfort level is 2% risk per trade, then 500.00 x .02 = $10.00 per trade. So $10.00/50=0.20 cents per pip risk which means we should set our lot size to 0.02. FAPTurbo’s Lot Risk Reductor does something similar, but it also decreases lot size as more and more trades are opened, thus decreasing risk as your account balance and margin change. When you manually set the lot size, each trade would be opened with the same lot size, even if your account balance is lower due to some losses.
If you are manually setting your lot sizes you need to revisit them regularly, they are not a set and forget item

Lot risk reductor (LRR)

The Scalper Lot Risk Reductor (LRR) in FAPTurbo works in conjunction with money management (MM). If you turn off MM, then the LRR will
have no effect. How does the LRR work? Basically it is used by FAPTurbo in the calculation of what size lot to open for a given trade. If you set the LRR to 5.0 you are telling FAPTurbo to use 5% of your available margin to open each trade. The amount of margin allocated determines the lot size FAPTurbo can open in conjunction with your accounts leverage and balance.
The first trade FAPTurbo opens will use 5% of your available margin and open a trade with the calculated lot size. The second trade FAPTurbo opens will use 5% of the remaining margin in your account to determine the appropriate lot size.
For example, if you have $500.00 available margin, FAPTurbo will use $25.00 of your margin to open it’s trade. You now have $475.00 in
available margin (excluding 1st trade profit/loss at time). If FAPTurbo needs to open a second trade, while the first trade is still running it will use 5% of the $475.00 to open this second trade, which would be $23.75 of your available margin, now leaving you with $451.25 of available margin. Due to this smaller margin amount the second trade may open a smaller lot size.
This lot sizing is dynamic, and is calculated at the time of the trade opening. As the calculation takes into account your current available margin, it is affected by current open positions. Open positions that are showing a loss decrease available margin in real time, and those at a profit increase available margin.
Also, margin is calculated using the underlying currency versus the currency of your account. If your account is in USD, and you want to trade the EURUSD pair, to buy 0.1 lots or $10,000.00 of the currency your broker will use the current rate of the underlying. In the EURUSD pair that is the EUR, so to buy $10,000.00 or 0.1 lots of EUR with a USD account you take the $10,000.00 and multiply it by the current EUR rate, say it is 1.3000, and the amount used to determine needed margin by your broker to make the trade is based on $13,000.00 USD.

Effect of 2% account balance risk versus 10% account balance risk

Assuming worst case scenario, here is the difference in your account if you risk 2% of your account balance versus 10%

Risking 2% of total account per trade

Trades – Account balance –
1 Start — $5000 – 100
2 $4900 — 98
3 $4802 — 96
4 $4706 — 94
5 $4612 — 92
6 $4520 — 90
7 $4430 — 89
8 $4341 — 87
9 $4254 — 85
10 $4169 — 17% of the account has been lost

Risking 10% of total account per trade

Trades — Account balance –
1 Start — $5000 — 500
2 $4500 — 450
3 $4050 — 405
4 $3645 — 364
5 $3281 — 328
6 $2953 — 295
7 $2658 — 265
8 $2392 — 239
9 $2153 — 215
10 $1938 — over 60% of the account has been lost

Stop loss level in FAPTurbo

Basically the SL in FAPTurbo, from what we have seen on the forum is around the 110 pip mark. Although each pair could be different and may also change with market conditions.

Leverage

Leverage in forex is like margin in stock and option trading. You are using the houses money to trade larger positions than you otherwise could.
Leverage in Forex comes in 1:25, 1:50, 1:100, 1:200, 1:300, 1:400, and 1:500. Leverage determines what amount of margin is needed to open a given lot size.
For example, to determine the margin needed to open a 0.1 lot on a $1000.00 account you divide the lot size in dollars by the leverage amount (see lot size and risk section for lot size to dollar conversion). So for a $10,000.00 lot size (0.1) with an account at 1:100
leverage and a balance in your account of $1000.00 you need $100.00 of available margin (10,000 / 100 = $100) (lotsize / margin = required
account margin).
If we change the margin from 1:100 to 1:200 then ($10,000 / 200 = $50.00) so you need $50.00 of available margin to buy 0.1 lots.
So leverage allows you to use less of your money, depending on the level your broker gives you, to buy the same amount of underlying currency.

Money management

Margin required has absolutely ZERO to do with risk. Here is why:

Same trader, same size account, same money management technique, two brokers, different margin requirement:

Say broker A’s margin requirement is 1% (1:100), Broker B’s margin requirement = 0.5% (1:200), account value is $5,000.00.

Trader decides to do a maximum trade (for him, following his MM) (10% of margin) at both brokers.

Broker A = buy $5,000 X 10% = $500 = at 1% of 10K (0.1 lot size) = 5 x 0.1 lots (or .5 lots). Notional transactional value = EUR 50,000 and value per pip $5.00.

Broker B = buy $5,000 X 10% = $500 = at 0.5% of 10K (0.1 lot size) = 10 x 0.1 lots (or 1.0 lots). Notional transactional value = EUR 100,000 and value per pip $10.00.

Let’s say the trade was not such a good idea. The eurusd moves 100 points in the wrong direction. With broker A he loses $500, with broker
B, $1000.

The solution is that you must calculate your risk not by using your margin required percentage but by looking at your leverage ratio:

Say broker A’s margin requirement is 1% (1:100), Broker B’s margin requirement = 0.5% (1:200)., account value is $5,000.00

Broker A = EUR50,000 (5 x 10K lots (5 x 0.1 lots or 1 x 0.5 lots))/ $5,000 (total capital) = leverage of 10:1. I.e. you take your capital, wish it is EUR50,000 (for which you give the broker some measily security of 1%) and off you go. Risking not 10% of what you have but risking what you have 10 times.

Broker B = EUR100,000 (10 x 10K lots (10 x 0.1 lots or 1 x 1.0 lots))/ $5,000 (total capital) = leverage of 20:1. I.e. you take your capital, wish it is EUR100,000 (for which you give the broker some measily security of 0.5%) and off you go. Risking not 10% of what you have but risking what you have 20 times.

Basically, higher leverage ratio = higher risk.

Because margin required is a variable it can not be used to judge the risk where the other properties of the transaction are all fixed (non-variable): Margin = $5000, lot size = EUR10,000 and pip value = $1.00/ per 10K. That is why you should look at the transaction from the notional value angle and not the variable margin requirement angle like most do.

Many traders say as part of “money management” that they will risk only say, 10% of their capital at any given time. What they mean is that they will do transactions to the value of 10% of their margin based on the margin requirement. This is WRONG. When assessing risk, you need to look at how much of your account balance (read as YOUR MONEY) you are risking with each trade.

Here is my approach - I keep my leverage down at 1:100, then I determine what lot size I am comfortable with based on the Stop Loss in use.

With FAPTurbo’s assumed SL at 110 pips, if I trade 0.1 lots, am I prepared to lose $110.00 on a trade gone bad? If the $110.00 is less than 2% of my account balance, then the answer is yes. If the $110.00 is more than 2%, then the answer is no, and I decrease my lot size to something that fits the maximum 2% risk of my account balance on any trade (see lot size and risk section for more detail).
For new or inexperienced traders I would recommend using FAPTurbo’s built in money management.

Hope this helps.

Regards and good trading,

Wayne

Courtesy: http://www.mymoneyblog.info/archives/56